January 2016 Alternative Investment Research

WHEN FINANCE MEETS INTERNET The Marketplace Lending Industry

Technology is changing our lives, from the way we communicate to the way we consume; now, it is the financial industry’s turn. This paper aims to envision the past, the present, and the future of the lending marketplaces, which will revolutionize the lending industry. Nine marketplace lenders were chosen, based on their size and influence on the marketplace, to illustrate di↵erent characteristics of lending platforms across countries (the U.K., the U.S., and China). The loan performance of four platforms will be compared.

When Finance Meets Internet

HJCO Capital Partners is a leading provider in the Netherlands for active and alternative investment solutions. The investment company is specialized in Marketplace Lending, active in research, portfolio management, and product structuring.

Arthur Hopstaken +31 10 205 1261 [email protected]

Willem Johannesma +31 10 205 1262 [email protected]

Erik Dieperink [email protected]

John Padding [email protected]

Max Schotsman [email protected]

Yaoyue Zhang [email protected]

3 When Finance Meets Internet Contents

Contents

Executive Summary 5

Introduction 6 AlternativeFinanceCategories ...... 7

Marketplace Lending: a Global Phenomenon 9 HistoryofOnlineLendingMarketplaces ...... 9 TrendsinMarketplaceLending ...... 11 Growth Factors of Marketplace Lending ...... 12 General Factors ...... 12 Region-specific Factors ...... 14 Benefits and Risks ...... 16 Business Model ...... 22 Regulation ...... 24 The Future of Marketplace Lending ...... 26

Due Diligence 28 Platform Comparison ...... 29 Loans Comparison ...... 36 Investing in Marketplace Lending ...... 46

Conclusion 48

Appendices 50 Appendix 1: Calculation of the Future of the Marketplace Lending ...... 50 Appendix2: HistoricalExchangeRates...... 57 Appendix3:CountryAbbreviations ...... 57

4 When Finance Meets Internet Executive Summary

Executive Summary

Peer-to-Peer lending (‘P2P lending’) or Marketplace lending (‘MPL’) creates a new investment opportunity. Through MPL platforms, investors can quickly choose whom they want to lend to and how much they would like to lend. The attractive risk-adjusted return, along with the ease of lending, has made this form of investment compelling in many countries. This paper illustrates the driving factors of Marketplace Lending, its current status, and possible future. It provides background and history, as well as a detailed description of the workings of MPL in di↵erent regions. The focus of this document is on the three largest MPL markets: the U.K., the U.S., and China. Platforms in other European countries are not included due to the fact that the market is fragmented, less accessible, not always transparent and the small size of platforms. The analysis starts with the di↵erence amongst platforms and then extends to the di↵erence between di↵erent loan types. This information can make the loan selection easier whenever an investor decides to invest in an MPL loan. As pioneers in MPL, the U.K. and the U.S. have more mature MPL platforms. Their well- developed credit systems contribute to the quick evolution of local platforms, whereas Chinese MPL develops rapidly due to borrowers’ lack of credit access. The loan performance varies over countries, which depends on how platforms deal with the default risk and the risk premium charged to borrowers. Due to di↵erent methods of pricing loans, platforms are not easy to compare. This paper gives an innovative insight into the risk and return of MPL loans. Despite the enormous growth of new global platform initiatives we have the opinion that investors have far less attractive options than borrowers due to the small size of most platforms, the immature stage of the platforms and/or the high risk profile of the borrowers. The most investable platforms share common characteristics; they are highly transparent, well organized and managed, and have a strong financial base. Borrowers are well profiled and risk models are strongly developed and continuously improved due to more available data. Based on our research we conclude that only a few platforms are serious investment options at the moment. Lending Club and Prosper are considered as the most attractive due to their risk models, IRR, and transparency. Other platforms will certainly follow, as marketplace lending becomes a bigger part of the global financial system.

5 When Finance Meets Internet Introduction

Introduction

Technology is changing our lives, from the way we communicate to the way we invest. In 2005, Peer-to-Peer lending (‘P2P Lending’) or Marketplace lending (‘MPL’) commenced as an alternative investment and has grown rapidly in recent years. We live in a highly sophisticated and interconnected world yet the banking system is still based on a centuries old model. The idea of P2P lending is to let borrowers lend from peers instead of traditional financial institutions so that borrowers are able to obtain loans at a lower interest rate and lenders or investors can earn higher risk-adjusted returns on their money compared to a savings account. To date, over $100 billion loans have been originated. We forecast the global MPL market to keep on growing, originating between $281 and $532 billion worth of loans in 2020.

Figure 1: The cumulative amount of Loans Originated via MPL Platforms, $bn

180

160 China

140

120

100

80

60

40 U.S. 20 U.K. - before 2012 2013 2014 2015 Q3 2012 Source: AltFi, Lending Club, Morgan Stanley Research estimates, Prosper, Wangdaizhijia, HJCO Capital Partners MPL contributes to the economy in numerous ways. It provides individuals and small- and medium-sized enterprises (‘SMEs’) with additional credit. It also makes money lending more ecient than traditional banks and saves operational costs for online lending platforms, considering the finding that banks have been inecient for decades. For example, Philippon (2012) shows that the cost of traditional financial intermediaries, such as banks, in the U.S. has remained between 1.5 and 2 percent of intermediated assets over the last 30 years. However, a Lending Club report1 shows that Lending Club (the largest U.S. consumer MPL platform) carries a60percentloweroperationalcostthanbanksduetoitselectronicservices.Furthermore,MPL platforms contribute to decreasing the systematic risk because unlike banks, they only match investors with borrowers, which means that there is no loan-related debt on their balance sheet.

1Renaud Laplanche, 2013, Transforming the Banking System, Lending Club, http://www.lendingmemo.com/ wp-content/uploads/2013/08/1.pdf

6 When Finance Meets Internet Introduction

Alternative Finance Categories Defining a constantly evolving and rapidly growing sector, such as MPL, is not an easy task, as platforms are aggressively seeking to come up with new ways of funding and to carve out new niches. Therefore, MPL goes by many di↵erent names and has many di↵erent meanings. For example, U.S. investors usually use the term “marketplace lending” whereas European investors would prefer “crowdfunding” or “P2P lending”. Considering the fact that nearly 65 percent2 of capital in MPL came from institutional lenders, “Peer-to-Peer” has become a misnomer and hence “Marketplace Lending” is a more suitable term. HJCO Capital Partners classifies MPL as a subcategory of Alternative Finance, which is divided into three categories: Marketplace Lending, Crowdfunding, and Micro Lending (see Figure 2). They have one thing in common: Financing is arranged through a platform and those providing capital know where their capital finally arrives. The platform is therefore a facilitator or an intermediary. Marketplace lending is the process by which investors (both individuals and institutions) lend money online, usually to individuals or to SMEs, without the use of traditional financial intermediaries such as banks.

Figure 2: Alternative Finance Categories

Consumer Credit Lending (P2P)

Marketplace Lending (Peer-to-Peer Lending) Business Loans Lending (P2B)

Others

Equity-based Crowdfunding Alternative Finance

Reward-based Crowdfunding Crowdfunding

Micro Lending Donation-based (Micro-Financing) Crowdfunding

Source: AltFi, Lending Club, HJCO Capital Partners Crowdfunding is a method used to raise monetary contributions from a large number of people to support a specific project or a business rather than to provide individuals with loans as done by MPL. Historically, crowd-funding has been used for political campaigns, disaster relief, governmental support, and public projects. More recently, it refers to equity-based crowdfunding, reward-based crowdfunding, or donation-based crowdfunding through sophisticated online plat- forms. Investors that invest through reward-based and donation-based crowdfunding platforms such as Kickstarter or Indiegogo usually receive the finished product, gifts, or discounts instead

2Shelly Banjo, March 1, 2015, Wall Street is Hogging the Peer-to-Peer Lending Market, Quartz, http://qz. com/355848/wall-street-is-hogging-the-peer-to-peer-lending-market, accessed September 16, 2015

7 When Finance Meets Internet Introduction of return on equity, compared to those who invest via equity-based crowdfunding platforms (e.g., Crowdcube and Syndicate Room). Micro Lending or Micro-Financing specifically refers to the financial help to low-income households in poverty areas and countries that do not have well-developed banking systems. Many of these loans are used to help finance medical bills, small businesses, education, and agricultural development. The most popular micro-lending institution in the U.S. is Kiva. As stated above, MPL keeps evolving and its model has expanded to various credit spec- tra, including the invoice financing3 (e.g., Market Invoice and Platform Black), student loans refinancing (SoFi and Upstart), mortgage loans (LendInvest), auto loans, and healthcare financ- ing. Nevertheless, this study will focus on unsecured consumer credit (non-student) loans and business loans due to their more attractive risk premium and well-developed lending models.

3Online Invoice Financing, sometimes called invoice trading, is where businesses can selectively sell individual unpaid invoices online in exchange for the majority of their value in cash immediately. It is classified as ‘Others’ under the MPL category.

8 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Marketplace Lending: a Global Phenomenon

History of Online Lending Marketplaces MPL started in the U.K. in 2005 with the launch of Zopa and spread to the U.S. in 2006, reaching China in 20074. In the U.K., Zopa issued the first consumer loan on March 4, 2005, and started the era of MPL. As the largest British lending marketplace, Zopa has a market share of 56 percent5 in the unsecured consumer credit lending. Another dominant player is RateSetter, which was launched in 2010 with the first provision fund. RateSetter currently occupies 42 percent of the unsecured consumer loan lending market. Compared to the unsecured consumer credit lending, the SME(s) lending is more fragmented; however, it is still clear that Funding Circle is the largest SME-only platform, with a 43 percent6 market share in the business MPL. There are also other fast-growing platforms such as LendInvest, which focuses on the real estate lending. In the U.S., Prosper is the first mover in MPL. When it was opened to the public in February 2006, it attracted 100,000 members and funded $20 million worth of loans within 9 months. Lending Club was launched in May 2007 as a Facebook application and emerged as a standalone website to compete directly with Prosper. As a result of the popularity and high default losses, MPL platforms attracted the regulatory authority’s attention and were required to complete the loans registration with the U.S. Securities and Exchange Commission (‘SEC’). Consequently, Lending Club experienced a six-month suspension from April to October 2008, whereas Prosper was suspended for a longer period, from October 2008 to July 2009. Due to a relatively lower default rate as well as active communication with regulators, Lending Club expanded quickly, caught up to Prosper, and became the largest U.S. online lending platform. Now, notes originated from platforms are o↵ered by a prospectus filed with the SEC. Since their “quiet period”, both Lending Club and Prosper have become more involved in risk management. Specifically, Prosper tightened its minimum credit requirements for borrowers to get a loan. This seems to have had a positive e↵ect; Prosper has rebuilt its reputation and attracted considerable institutional capital. Following the U.K. and the U.S., many countries such as China, Germany, Japan, and Switzerland started MPL platforms with some region-specific characteristics. Figure 3 plots the timeline of the development of the main platforms in each country, implying that MPL boomed worldwide in 2012.

4MPL in China started with an o✏ine pattern in 2006 with the opening of CreditEase, which provides both SMEs loans and consumer loans. However, not until 2012 did it launch the online lending platform, Yirendai. The first online platform in China is PPdai, started in 2007. 5Zopa has originated £1,053,279,013 and RateSetter has funded £784,788,985, with the total consumer loans of £1,871,102,832, http://www.altfi.com/data/indices/UKvolume, accessed September 16, 2015 from Altfi. 6Funding Circle has made £816,000,760 loans and the total business loans are £1,876,366,089, http://www. altfi.com/data/indices/UKvolume, accessed September 16, 2015

9 When Finance Meets Internet Marketplace Lending: a Global Phenomenon (AE) Beehive Grouplend(CA) (NZ) Harmoney (LV) Mintos Bitbond (Global) (FR) Unilend Lending Works Lending(UK) (AR) Afluenta (CN) Yirendai CN) (IT) Smartika Lu (formerly Lufax,Lu (formerly (FR) Prêt D'union D'union Prêt (IN) FairCent (NL) (AU) SocietyOne Geldvoorelkaar.nl (CN) (UK) Renrendai Funding CircleFunding (UK) (FI) (BR) Fixura Fairplace RateSetter Community Community Micro Lending (CA) (ES) Comunitae (CN) (JP) Hongling Aqush (SE) TrustBuddy Figure 3: Timeline of Lending Marketplaces (EE) (JP) Bondora Maneo (CH) Cashare (CN) PPdai (US) (US) Lending ClubLending (DE) OnDeck Auxmoney (CN) CreditEase (US) Prosper (DE) Smava Zopa Zopa (UK) Platforms below the horizontal axis are business loans lenders and platforms above are consumer loans lenders. The absolute height of bar represents the amount of funded loans by September 30, 2015. ⇤ ⇤⇤ Source: AltFi, Company Data, wangdaizhijia, HJCO Capital Partners

10 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Figure 4: Market Share of Marketplace Lenders in the World by Loan Amount, $ bn

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2010 2011 2012 2013 2014

UK US* China** Others***

⇤Lending Club, Prosper and SMEs Lending ⇤⇤Data is di↵erent from Liberum ($1.9 bn in 2013) and Morgan Stanley ($3 bn in 2013 and $8.9 bn in 2014) ⇤⇤⇤Europe excluding the U.K. Source: AltFi, Lending Club, Morgan Stanley Research estimates, Prosper, Wangdaizhijia, Zhongshangqingbaowang, HJCO Capital Partners Figure 4 displays the market share across countries from 2010 to 2014. Lending platforms from the U.K., the U.S., and China have dominated the market, with the Chinese MPL market having the largest share.

Trends in Marketplace Lending The following are the current trends of MPL industry:

To date, the largest online consumer MPL platform is Lending Club, and the • largest online business MPL platform is Hongling. In fact, both platforms supply business loans and unsecured consumer loans; however, Lending Club focuses on unsecured consumer loans while Hongling concentrates on business loans. MPL platforms seek to carve out new niches and come up with new ways of • financing. For example, RateSetter (a U.K. platform) started a provision fund to cover the default loss of loans. SoFi (a U.S. platform) began with refinancing student loans from customers with degrees from the top-ranked universities in the U.S. and now even o↵er soft-skill training to borrowers who lose their job. LendInvest (a U.K. platform) exclusively provides loans secured by real estate. Some new marketplace lenders start unique di↵erent segments of the credit spectra. Avant (a U.S. platform) is targeting near- prime borrowers with no FICO scores. Upstart (a U.S. platform) underwrites credits using undergraduate grades of borrowers. Moreover, Bitbond connects investors and borrowers globally by providing bitcoin financing. MPL platforms have been evolving their service models. In July 2009, Prosper • changed its interest rate determination policy from a Dutch auction-like system to pre-set rates determined by Prosper Rating. In February 2012, it set up Prosper Funding LLC and transferred all loan operations to Prosper Funding to protect investors against all the

11 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

obligations of its parent company: Prosper MarketPlace. This means that if Prosper goes bankrupt, loans would theoretically be una↵ected. Zopa launched its Safeguard in 2013 to compensate investors for default losses to certain extent. MPL platforms are expanding their business to other nations or other credit • spectra. RateSetter expanded to Australia in 2014, following Funding Circle’s (the largest U.K. business loans lender) move to the U.S. in 2013. Lending Club included healthcare fi- nancing as a part of its business by acquiring Springstone in 2014 and Prosper also expanded into healthcare financing through the acquisition of American Health Lending in January 2015. SoFi has introduced new products to their line such as mortgages and unsecured consumer loans. MPL platforms are becoming more transparent in order to attract investors • and capital. On December 10, 2014, Lending Club went public and raised $900 million. This gave Lending Club a market capitalization of $8.5 billion. OnDeck (a U.S. business loans lender) that was listed on December 18, 2014 is the first public SMEs loans lender. The listing of platforms ensures more transparency, tighter regulation from the government, and monitoring from the public. Besides going public, more platforms have opened their loan books to the public as Lending Club and Prosper did. In the U.K., Zopa, RateSet- ter, Funding Circle, Landbay (a consumer loan lender specifically for residential buy-to-let mortgages), and LendInvest disclosed their loan books after the involvement of the reg- ulatory regime Financial Conduct Authority (‘FCA’) in April 2014. Bondora (a Spanish marketplace lender) also shares its loan book on the ocial website. Financial institutions actively react to MPL. Some financial institutions are planning • to enter MPL by building or buying an online lending MPL platform. These institutions are starting to set up online interfaces similar to those of online marketplace lenders. For example, Ping An, the second largest insurance company in China, launched Lu (formerly Lufax) in 2012. Goldman Sachs, the underwriter of the Lending Club IPO, is planning to build its own MPL platform and o↵er loans to ordinary Americans. Hargreaves Lansdowne, a financial service company based in Bristol, has also confirmed its participation in the MPL sector. JPMorgan Chase, the largest bank in the U.S., announced on December 1, 2015, an agreement with OnDeck to provide loans to small businesses, showing the interest of the old finance institutions in the new world of finance. Additionally, private equity firms aggressively provide growth capital to marketplace lenders. A recent example is KKR’s $400 million primary investment in Avant. Some Internet corporations such as Alibaba, which launched Zhaocaibao on April 25, 2014, also moved to MPL industry.

Growth Factors of Marketplace Lending There are some common reasons behind the rapid growth of MPL and also some region-specific reasons accounting for the di↵erent progress of MPL across countries.

General Factors 1. Technology. Technology-driven marketplace lenders benefit from the advance of technol- ogy, such as the internet and the processing of big data. Firstly, the fact that borrowers can create their profile online allows platforms to match investors to targeted borrowers. Secondly, the internet-based nature of MPL makes it possible for MPL platforms to o↵er

12 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

cheap credit and ecient loan application processes for borrowers and quick investment products for investors. Thirdly, the analytical ability of big data allows platforms to build up reliable and empirical models to evaluate the creditworthiness and default probability of borrowers. Lastly, the availability of large datasets concerning loans allows investors to evaluate loans completely and make better investment decisions. 2. Demographic. The labor force of each country consists for a large part (e.g., 34 per- cent of the current U.S. labor force7) of Millennials (i.e., born between 1982 and 1997)8. These laborers are increasingly in need of financial services, but are often underserved by traditional banking systems.

Figure 5: Marketplace Lender Awareness and Use by age

Unware Aware but not used Used

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0% Total 18-34 35-54 55+

Source: Morgan Stanley Research Many surveys (e.g., the AlphaWise survey conducted by Morgan Stanley) show that Mil- lennials favor fast, convenient, and cheaper credits. They increasingly perform transactions online and through mobile apps9. This familiarity with online financial decisions would significantly benefit marketplace lenders. The Small Business Owner Report10 from Bank of America shows that 25 percent of Millennials have been taking advantages of alternative financing sources such as MPL platforms (14 percent) and micro lenders (11 percent). 3. Capital Needs. After the 2008 crisis, banks have been tightly regulated on lending to SMEs and individuals under the new and strict capital adequacy regulations from Basel III.

7Richard FRY, May 1, 2015, Millennials Surpass Gen Xers as the Largest Generation in U.S. La- bor Force, http://www.pewresearch.org/fact-tank/2015/05/11/millennials-surpass-gen-xers-as-the- largest-generaion-in-u-s-labor-force, accessed September 16, 2015 8The definition of Millennials is di↵erent, depending on the sources. For instance, a global generation study conducted by PricewaterhouseCoopers with the University of Southern California and the London Business School in 2013 defines Millennials as those born between 1980 and 1995. A Time magazine in May 2013 cover story, Millennials: the Me Me Me Generation, identifies Millennials as those born from 1980 or 1981 to 2000. A Morgan Stanley research conducted in April 2015 defines Millennials as those who age 18-31. 9Mary Meeker, 2015, Internet Trends 2015-Code Conference, Kleiner Perkins Caufield Byers, see http:// www.kpcb.com/internet-trends 10Bank of American, 2014, Small Business Owner Report

13 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Also, banks have reduced credit supply after su↵ering heavy credit losses during the financial crisis. According to Pierrakis and Collins (2013) and Mills and McCarthy (2014), the drop of lending to SMEs and individuals during the crisis left a credit gap in the market. The National Federation of Independent Businesses (‘NFIB’) survey11 in May 2014 indicates that small businesses think that the credit access at the time was tighter compared to three months before. Stein, Ardic, and Hommes (2013) suggests that the credit gap is a global phenomenon and estimates the total unmet demand for credit by all Micro, Small, and Medium Enterprises (‘MSMEs’) today to be between $3.2 and $3.9 trillion, which equals 30 to 36 percent of the current outstanding MSMEs credit. 4. Interest Rate Environment. The Risk Outlook 2013-2014 of the International Organi- zation of Securities Commission (‘IOSCO’)12 points out that quantitative easing in many jurisdictions has driven the yield on treasury bonds close to zero or lower, which leads investors towards alternative investments. This results in an increasing demand for a bond alternative with high returns 5. Regulatory Advantage. As a new phenomenon, MPL experienced fewer regulations than traditional financial institutions, and thus a majority of these platforms operate based on amarketplacemodelanddonottaketraditionalcreditrisks.Thisallowsthemtooperate with more capital eciency and lower regulatory overhead costs. The U.K. government considers MPL as a supplement to the traditional financial industry and supports MPL as an extra credit channel for small businesses. The U.S. marketplace lenders are not directly regulated by the Federal Deposit Insurance Corporation (‘FDIC’), which enables MPL platforms to o↵er more flexible interest rates to borrowers and investors. For the Chinese online finance market, the guideline was not released until July 18, 2015. It tends to create a healthy and supportive environment for marketplace lenders. 6. Low Threshold of Investments. To diversify investors’ loan portfolios, marketplace lenders split loans into thousands of notes so that investors can start their investments with very little money. For example, the minimum investment requirement is £10 on Zopa and $25 on Prosper. This arouses the interest of small investors, whose investments can add up quite significantly.

Region-specific Factors The credit consuming culture has helped the U.K. and the U.S. to build a complete credit system, which is the inherent advantage for the start-up lending marketplaces. Consumer credit information is easily available for platforms through rating agencies. A lower borrowing rate on platforms than that of credit cards is the main reason for the popularity of MPL. Lending Club’s statistics shows that 67.70 percent13 of its borrowers use loans to refinance existing loans or pay o↵ their credit card debts. Things are totally di↵erent in China. The incomplete credit system and restricted access to the credit reference database from the central bank of China forces most platforms to execute o✏ine evaluation of the creditworthiness of clients. On the one hand, this significantly increases

11William C. Dunkelberg and Holly Wade, 2014, NFIB Small Business Economic Trends, National Federal of Independent Business 12Eleanor Kirby and Shane Worner, 2014, Crowd-funding: an Infant Industry Growing Fast, OICU-IOSCO stu↵ working paper 13As of September 30, 2015

14 When Finance Meets Internet Marketplace Lending: a Global Phenomenon the operational cost of platforms, but on the other hand, this causes the default risk to decline because platforms usually require loans to be fully secured or guaranteed by a creditworthy third-party. In China, the majority of borrowers are SMEs whose main purpose is to acquire short-term working capital or start-up funds14. There are more than 55 million Small and Micro Enterprises in China that employ 27.5 percent of the national workforce and contribute 24.3 percent of the GDP, yet more than half are not able to access bank loans, according to the CHFS survey15. This is due to the fact that state-backed banks prefer to lend to large firms and enterprises aliated to local governments. The supportive attitude of the U.K. government alleviates the regulations and increases the confidence of investors and borrowers on MPL. In March 2013, the British government invested £2million16 in Funding Circle through the Business Finance Partnership (BFP), a scheme that led to the current Business Bank Investment Program. In March 2014, the British Business Bank Investment program commenced another £40 million17 investment in Funding Circle loans. Other MPL platforms that have received investment from the U.K. government include Zopa (£10m)18 and Market Invoice (£5m)19. Apart from government support, the low levels of satisfaction from the British public towards bank servicing also contributed to the rapid growth of MPL. Outside of the U.K., MPL has gained limited traction in Europe to date, due to the fact that the U.K. has over 80 percent of the European MPL market (see Figure 6). The large market share of the U.K. can be explained by four factors: 1. Regulatory Approach. Marketplace lenders are regulated as banks in mainland Europe (e.g., France, Germany, and Italy). 2. Penetration of Credit Cards. People are more accustomed to using credit cards in the U.K. compared to rest of Europe. 3. Access to Credit Information. The U.K. has easy access to credit information compared to some countries in mainland Europe (e.g., Spain, France, and Switzerland). 4. Government’s Attention. Local governments do not pay enough attention to this new phenomenon. Consequently, the regulation is far from established in some countries, re- sulting in less legality and trust towards MPL.

14Lu, 2015, Report on Internet Finance: Focus on P2P Lending 15China Household Finance Survey (‘CHFS’), 2014, Chinese SMEs Development Report, Southwestern Uni- versity of Finance and Economics 16The scheme is available at British Business Bank (http://british-business-bank.co.uk/300-million- boost-for-sme-lending-in-first-phase-of-british-business-bank) and the amount of funding is avail- able at Funding Circle (https://www.fundingcircle.com/uk/businesses). 17Department for Business, Innovation & Skills and the Rt Hon Dr Vince Cable, February 25, 2014, New £40m Investment by British Business Bank to Support £450m of Lending to Smaller Busi- nesses, https://www.gov.uk/government/news/new-40-million-investment-by-british-business-bank- to-support-450-million-of-lending-to-smaller-businesses, accessed September 17, 2015 18Sean Farrell, August 12, 2013, Zopa on Fast Track to Alternative Success, http://www.theguardian.com/ business/2013/aug/12/zopa-business-lender-online-broker, accessed September 16, 2015 19Department for Business, Innovation & Skills and the Rt Hon Dr Vince Cable, March 22, 2013, £70 mil- lion boost to small business lending, https://www.gov.uk/government/news/70-million-boost-to-small- business-lending, accessed September 17, 2015

15 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Figure 6: Loans Originating in Europe, emn

2,500

2,000

1,500

1,000

500

- 2010 2011 2012 2013 2014 2015 Q3

Europe (excluding the U.K.) the U.K.

Source: AltFi, HJCO Capital Partners In the U.S., the securitization of loans is a key enabler of the rapid growth of MPL. The securitization of notes allows some lenders, such as pension funds and insurance companies that have been held back due to the small size and lack of liquidity of MPL loans, to invest in MPL. Besides, using credit funds, asset management firms are able provide a funding source by purchasing and holding loans originated via online platforms. Recent examples include the BlackRock’s purchase of $330 million loans from Prosper and the commitment of KKR’s $400 million for newly originated loans from Avant. Additionally, that major rating agencies have begun to rate these deals further increases investors’ confidence in the market. For example, $200 million loans made on CAN Capital (a U.S. business loan provider) have received “A” rating from S&P on October 20, 2014; $303 million loans originated from SoFi have achieved “A” rating from S&P and “A2” from Moody’s on November 10, 2014; $327 million loans funded through Prosper have achieved “Baa3” rating (investment-grade) from Moody’s on February 6, 2015. In China, the guarantee on the principal and returns, as well as other various methods used to reduce loan risks, enables the fast growth of MPL. A loan will be less risky if it is sustained by a reliable platform, so platforms with more reputable backers (such venture capitalists, state- owned enterprises, listed firms, and banks) are able to attract more investors and borrowers. Until June 2015, 55 platforms received their equity investment from venture capitalists. The number of platforms that were backed by public firms is 42, 59 platforms are founded by state- owned enterprises and 13 by banks. Some MPL platforms have a combination of funders20.

Benefits and Risks We briefly discussed some advantages of MPL in the introduction of this paper. In this section we will go into more detail regarding the pros and cons of MPL. Benefits are illustrated from three perspectives: investors, borrowers, and the whole economy, whereas risks are primarily discussed for investors, as risks are limited for borrowers and the platforms themselves.

20Wangdaizhijia, July 8, 2015, the Semi-Annual Report of China Online Lending, http://www.wdzj.com/ news/baogao/20950.html, accessed September 17, 2015

16 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Benefits for Investors 1. High Risk-Adjusted Return. Lenders can achieve a high return, and the idiosyncratic risk that investors have to bear can be reduced through diversification in multiple loans21. Lenders of Lending Club have been able to earn a median net return of 8.6 percent on a three-year loan, which is more attractive than the 1 percent return that the depositors who keep their funds in a three-year certificate of deposit account are currently able to obtain (see Figure 7).

Figure 7: Interest Rate for Borrowers and Lenders: Lending Club vs. Banks

Source: Company Data, Lending Club, Morgan Stanley Research, HJCO Capital Partners 2. A New Choice for Portfolio Diversification. MPL provides investors with a new asset class, which has a low correlation with other asset classes (see Table 1), according to the Lending Robot simulation22. Therefore, investors are able to further diversify their investments and lower the portfolio volatility, resulting in lower systematic risk.

Table 1: Correlation between Major Asset Classes, including Marketplace Lending

US Stock PAC Stock EU Stock US SmallCap Real Estate US Bonds US Tips High Yield Bonds MPL US Stock 1 PAC Stock 0.85 1 EU Stock 0.88 0.88 1 US SmallCap 0.96 0.80 0.82 1 Real Estate 0.82 0.69 0.71 0.86 1 US Bonds 0.08 0.14 0.14 0.07 0.26 1 US Tips 0.09 0.14 0.15 0.07 0.28 0.76 1 High Yield Bonds 0.75 0.67 0.70 0.72 0.69 0.32 0.33 1 MPL 0.19 0.14 0.14 0.13 0.18 -0.13 -0.02 0.01 1 Source: Lending Robot Research

3. Convenience. Online platforms are more accessible as users can manage their portfolios easily via mobile phones or computers at any given time. 4. Low Threshold of Investments. The minimum amount of investments is small (e.g., £10 on the U.K. platforms, $25 on the U.S. platforms, and RMB100 on China platforms) due to the loan splitting. 21Most platforms (e.g., Lending Club, Prosper, and Zopa) split and restructure loans so that investors are able to buy a small proportion of a loan and diversify their portfolio as much as possible; some platforms (e.g., RateSetter) do not split loans, so investors are allowed to buy a whole loan. 22LendingRobot Research, 2015, How Much Should You Invest in Marketplace Lending

17 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Benefits for Borrowers 1. Low APR. The lower administrative service fees charged by marketplace lenders reduce the cost of capital for borrowers. Based on a survey of 21,000 borrowers on Lending Club, interest rates paid on loans obtained from Lending Club are on average 7 percent23 lower than the rate on their outstanding debt (see Figure 7). The SMEs lending in China is a prominent case. Currently, a large amount of SMEs credit demand is filled by very high-cost channels in China, such as micro lending, underground lending, and high-interest private lending (see Table 2).

Table 2: Estimated Alternative Finance Channel Size in China

Alternative Finance Channel Balance (RMB bn) Interest Rate (%) Trust loans 8,6051 12.40 Entrust loans 8,5021 13.76 Interbank entrusted payment 100 4.41 Pawn shop loans 85 19.54 Asset cross sale via financial 1,000 12.38 asset exchange Underground lending 3,389 19.54 Financial leasing 2,800 10.35 Micro lending 9001 19.54 Asset management companies 1,600 12.00 Marketplace lending 100 13.76 Stock pledged loans 40 8.26 High-interest private lending 7,500 18.102 Undiscounted bank acceptance 7,3281 4.41 Total alternative financing 41,860 9.70 1 People’s Bank of China 2 China Household Finance Survey Other Sources: Ministry of Commerce, Morgan Stanley Research estimates, HJCO Capital Partners

2. Alternative Access to Credit. MPL plays a positive role in promoting the credit access for SMEs. According to the 2014 Joint Small Business Credit Survey Report 24 conducted by Federal Reserve Bank of New York, Atlanta, Cleveland, and Philadelphia, although 42 percent of SMEs have outstanding debt, 18 percent of them have faced the business challenge of the lack of credit availability. In China, 42.2 percent of SMEs who have capital need but do not look for credits from banks due to the high threshold of bank borrowing, stated by the CHFS Small- and Micro- Enterprises survey 25. In the U.K., the approval rate of banks is as low as 22 percent, showed by the Nesta Report26. With the inception of MPL, borrowers, especially SMEs, have alternative ways to acquire credit.

23Based on responses from 14,986 borrowers in a survey of 70,150 randomly selected borrowers conducted from July 1, 2014-July 1, 2015, borrowers who received a loan to consolidate existing debt or pay o↵ their credit card balance reported that the interest rate on outstanding debt or credit cards was 21.8 percent and average interest rate on loans via Lending Club is 14.8 percent. 24The Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia, 2014, Joint Small Business Credit Survey Report 25China Household Finance Survey (‘CHFS’), 2014, Chinese SMEs Development Report, Southwestern Uni- versity of Finance and Economics 26Peter Baeck, Liam Collins, and Bryan Zhang, 2014, Understanding Alternative Finance, Nesta and the University of Cambridge

18 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

3. A Better Financial Situation. With MPL loans such as a credit card debt consolidation loan, people can get their bills under control, with a better interest rate and only one tidy monthly payment automatically deducted from their bank account. People who make minimum payments or even less than the minimum can improve their financial situation, with less worry about the increasing interest rates and a worse credit score.

Benefits for the Economy 1. Cost Eciency. Unlike banks, lending marketplaces can do all their business online; therefore high-cost physical oces are not necessary for client contact, resulting in much lower infrastructural costs. Their employee need is also lower than that of traditional banks. Zopa, the largest U.K. online marketplace lender, has only 97 employees in London. A Lending Club report27 shows that its operational costs are 60 percent lower than traditional banks’ for performing the same service. 2. Contribution to Economic Growth. It provides SMEs with more channels to acquire credit and therefore contributes to the growth of SMEs. As an important engine of economic growth, SME helps with job creation and economic recovery. This is the most important reason that governments encourage this innovative capital funding form. 3. Filling the Gap Left by Banks. The tightening restrictions on traditional lenders make it harder for borrowers to get loans from banks; what’s worse, banks are unwilling to lend money. MPL o↵ers an alternative to traditional lending for individual consumers and SMEs. 4. Bringing New Competition to the Traditional Financial Industry. The combina- tion of user-friendly and ecient systems can revolutionize the traditional financial industry. It creates incentives for traditional entities to innovate, reduce cost, and become more e- cient. This will not only help borrowers to access credit in a timely manner but also reduce the cost of contracting a loan. Additionally, the competition of traditional institutions with online platforms may result in better interest rates for investors and borrowers. 5. Lowering Systematic Risk. With marketplace lenders, the risk traditional banks bear are transferred to the loans purchasers, reducing the source of systematic risks. Systematic risk is defined as the risk that cannot be eliminated through diversification, that is, the risk is inherent to the system itself. When banks lend capital to borrowers, the debts are on the balance sheet of the bank; therefore, if a loan defaults, it is the bank that su↵ers the loss. If investors are able to lend money directly to borrowers via platforms, the debts then are on investors’ balance sheets and not on the platforms (although a few platforms (e.g., OnDeck) do put loans on their own balance sheets). This means that if a loan defaults, investors have to undertake the loss themselves. In other words, a decentralized financial system has greater financial resilience by eliminating the single point of failure that traditional banks have. Also, the nature of MPL reduces the leverage of the financial system. Banks normally only have approximately 10-14 percent equity on their balance sheets.

Risks for Investors 1. Risk of Fraud. MPL faces a risk of fraud due to its dependence on the Internet. Investors can only make decisions based on the interest rate assigned by platforms and some soft

27Renaud Laplanche, 2013, Transforming the Banking System, Lending Club, http://www.lendingmemo.com/ wp-content/uploads/2013/08/1.pdf

19 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

information28 about borrowers. Platforms do not verify all the information provided by borrowers, which means that investors may be misled by borrowers. 2. Default Risk. The industry imposed strict rules on itself to categorize borrowers into di↵erent rating classes. These investment criteria result in 1 out of 10 loans being accepted by Lending Club and Prosper29, and the rejection rate of RateSetter to be over 85 percent30, while it is 50 percent31 on Zopa. Other platforms have a similarly low acceptance rate. The consequence is that a current overall default rate is reported to be in the range of 0.2-7 percent, depending on the platform. However, most loans funded on platforms are unsecured, which means that there is no collateral and compensation if a loan defaults. Even though platforms or third-parties carry out debt collection, the likelihood of regaining the principal of a defaulted loan is very low, not to mention the costly collection process. Note that di↵erent platforms have di↵erent policies on defaulted loans. For example, Prosper has adopted a new way of handling charged-o↵ loans. These loans are lumped together on amonthlybasisandsoldtoathird-partythatwillcollecttheoutstandingdebtforitself. The investor receives an amount proportional to the charged-o↵ amount of his loan(s). 3. Platform Risk. The platform risk is the risk that a platform is temporarily closed or permanently bankrupt. If a platform closes, loans would be exposed to risks of not being repaid as the intermediary function, responsible for the repayment collection cannot be fulfilled. In the event of a bankruptcy, the borrowers’ commitment might also decrease. Some platforms open a segregated account for investors and borrowers so that clients’ money goes through a segregated account instead of the account of platforms. Some platforms have a bankruptcy remote system or have assigned a third-party to take over their business. These actions lessen the impact of the failure of platforms, but still, not all platforms have these policies to protect investors. 4. Constrained Demand. More institutional investors are paying attention to MPL. In January 2015, BlackRock funded $330 million of consumer debt through Prosper. After that, billions of dollars have flowed into the MPL industry, resulting in increasing diculty to find higher-yield investments. According to the latest quarterly report of Prosper, in the first nine months of 2015, nearly 90 percent of total loans were funded through its Whole Loan Channel, which is specified for accredited investors, compared to 64 percent Whole Loans over the entire period. The limited number of borrowers may incentivize platforms to issue higher risk loans, unbeknownst to investors, which was a large part of the cause of the subprime mortgage collapse in 2008. To ensure the quality of loans, the origination speed may slow down. 5. Liquidity Risk. Firstly, MPL investments often lack the possibility of being traded on a

28Soft information refers to the qualitative data, such as a narrative or a picture provided by borrowers or the purpose of loans. 29Bill Kassul, January 8, 2014, Peer-to-Peer Lending Opportunities Opening up for Advisors, http://wealthmanagement.com/viewpoints/peer-peer-lending-opportunities-opening-advisors, accessed September 16, 2015 30RateSetter, see: FQA for investors: Should I diversify my loans?, https://www.ratesetter.com/lend/faq, accessed September 16, 2015 31Justin Schamotta, August 7, 2014, Is Peer to Peer Lending Worth the Risk?, http://www.choose.net/ money/guide/faqs/peer-to-peer-lending-worth-risk.html, accessed September 24, 2015. Note that a lower rejection rate does not necessarily mean that Zopa has a less strict credit policy than other platforms. Both the application and rejection rate lead to the entire credit borrowers obtain.

20 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

secondary market. This means that in most cases, investor’s money is locked into a contract and cannot be sold to others. Secondly, even though some lending marketplaces do have secondary markets (e.g., Zopa, Lending Club, and Prosper), these secondary markets are not as active as the primary market or other financial markets (such as the stock market). A significant discount on the face value is very likely to give up to resell a loan. Besides, these secondary markets operate separately, which means that investors can only resell loans within the same platform. 6. Prepayment Risk. The Fed typically lowers the interest rate to stimulate the economy during periods of economic instability. If the interest rate is low, borrowers would like to prepay loans and borrow money at a lower rate, resulting in a lower return for investors. 7. Economic Cycle Dependence. Default rates are significantly a↵ected by economic downturns or general economic conditions beyond the Platforms’ control and beyond the control of individual borrowers. In particular, default rates on borrower loans are expected to increase during economic downturns with increasing national unemployment rate in the United States. It has not yet to be tested in a meaningful way how MPL model would fare in an economic downturn due to its short existence. As Figure 8 shows, the recent recession created a higher delinquency and charged-o↵ rate for both credit card loans and business loans. Figure 8: Charged-o↵ Rate on Consumer Loans, Business Loans and All Loans

(%) 7

* Shaded areas indicate the 6 U.S. recessions

5

Charged-off rate on 4 all loans

Charged-off rate on 3 consumer loans

2

Charged-off rate on 1 business loans

0 1985 1989 1993 1997 2001 2005 2009 2013

Source: Economic Research of Federal Reserve Bank of st. Louis, HJCO Capital Partners 8. Risk of Cyber-Attack. As online MPL platforms are Internet-based, there is risk re- lated to cyber-security. This could come in many forms, from overloading the platform’s infrastructure to confusing accounts or identity theft. The platform’s creators may need to ensure that they have enough technical expertise to prevent such cyber-security issues.

Risks for the MPL Industry 1. Tightening Regulation. traditional credit lending is highly regulated. One major ad- vantage of marketplace lenders over traditional bank lenders is the amount of regulatory

21 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

oversight that they avoid, which allows them to operate with lower operational and regula- tory costs than traditional banks. The risk is that as this industry matures and becomes a more meaningful part of the financial system, heightened regulatory scrutiny could become inevitable and regulators may come up with new rules such as risk retention requirements. Therefore, this kind of cost-advantage may diminish over time.

Business Model MPL platforms are diverse in terms of business models. Following Kirby and Worner (2014), we have identified three types of MPL platforms. Note that there could be others developing out there in the world, as it is a fast-moving concept. 1. Client Segregated Account Model. Individual lenders are matched to an individual borrower through an intermediary platform, and a contract is set up between the individ- uals with little participation of the intermediary platform. Usually, the interest rates are determined by the intermediary (e.g., Zopa and ThinCats) prior to the loan being o↵ered to investors. However, on some platforms, for example Funding Circle, lenders can bid on loans in an auction style through the automated bidding option32; under the RateSetter mechanism, lenders can specify a singular desired rate. All funds are separated from the balance sheet of platforms and go through a legally segregated client account, over which the platform has no claim and the contractual obligation between borrowers and lenders still is e↵ective in the event of the platform’s failure. Most platforms charge fees to both lenders and borrowers. Borrowers pay an origination fee (usually as a percentage of the loan amount funded) based on their credit ratings; late fees and an administration fee are also applicable, depending on the platform (e.g., RateSetter does not charge the administration fee to lenders). In addition, if lenders want to withdraw their investments, some fees may be charged. The platform assesses the borrower’s credit, matches investors with borrowers, and is responsible for collecting loan repayments. Zopa and RateSetter apply this model. A variation of Client Segregated Account Model is one based on a trust fund, through which lenders purchase units or shares in a trust structure, with the platform acting as the trustee to manage the fund. The platform then uses the fund to issue loans to borrowers, allowing lenders to choose whom they finance. The platform is responsible for managing loans and repayments. In this model, investors’ money is legally distanced from the platform, thereby safeguarding investors from a platform’s failure. This model is-amongst others-used by Afluenta, based in Argentina. 2. Notary Model. The term ‘notary’ stems from the issuance of notes instead of contracts. As in other models, a platform acts as an intermediary between lenders and borrowers and helps match them with each other. Lenders choose loans they want in their portfolio. Once the amount of money required has been reached, the loan would be issued by a partner bank. The platform then issues a note to lenders at the value of their contribution to the loan. This note is essentially a security. The fee structure is similar to that in the client segregated account model. This model is popular in the U.S.;both Prosper and Lending Club use it. 32Since September 28, 2015, investors can only bid at fixed rates for new loan requests. Autobid is available when buy parts of existing loans from other investors.

22 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Figure 9: Three Business Models of Marketplace Lending

1. Client Segregated Account Model

Investor

Money Invest Loan Originated Investor Client Account Borrower Repayment Repayment (Guaranteed Principal or Principal and Returns) Investor Marketplace Lender Services Services 2. Notary Model Investor

Money Invest Repayment Investor Marketplace Lender Non-recourse Note and Purchase Non-recourse Assignment of Repayment Loan Loan Promissory Note Investor Loan Originated Bank Borrower Loan Promissory Note 3. Guaranteed Return Model Investor

Money Invest Loan Originated Investor Borrower Marketplace Lender Guaranteed Repayment Principal and Return Investor

Source: IOSCO, HJCO Capital Partners 3. Guaranteed Return Model. This model allows lenders to invest in MPL loans through an intermediary platform at a pre-set return on the investment guaranteed by the interme- diary platform. Most platforms in China took this model in the past. Usually, the investors choose loans based on the usage of loans and the revenue source, the financial status, and the performance of the borrowers. Investors are only allowed to go for limited projects. Due to the unsound consumer credit system, no access to the credit reference database, and borrowers’ unfamiliarity with online financing, most Chinese platforms have to carry out o✏ine credit assessment. For example, CreditEase, the largest platform in China, has its own branches in 182 cities and 62 rural areas. It provides direct channels to borrowers and manually assesses borrowers’ credit. According to the F-1 form filed to the U.S. Se- curities and Exchange Commission (’SEC’), around 60 percent of loans facilitated through

23 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

its online platform, Yirendai, are generated from o✏ine channels. The o✏ine evaluation increases platforms’ costs, but is useful to attract borrowers, especially farmers, who cannot obtain the capital they need from banks and are not familiar with the internet. After the o✏ine assessment, loans are listed on its online platform so that lenders are able to invest. Once a loan is issued the platform will collect repayments on behalf of lenders. The platform guarantees a return of between 8 and 10 percent on the investment by o↵ering compensation in the event of a borrower’s default. However, with the release of the guide- line of internet financing, platforms can only operate as an information intermediary and are not allowed to assess the creditworthiness of borrowers or increase the attractiveness of loans (e.g., via guaranteeing returns). The only possibility to assess borrowers’ credit is via third-party rating agencies or through the credit reference database provided by CBOC. If platforms still choose to guarantee principals and returns, they can only employ a third- party guarantee agency, use provision funds, or provide insurance contracts. We expect the new operational models of Chinese platforms to be a combination of Client Segregated Account Model and Guaranteed Returns Model.

Regulation The regulatory environment for MPL varies across countries. Currently, most platforms are regulated by local financial regulatory authorities; some countries do not have a regulatory body responsible for MPL; MPL may even be less-defined in some regions. As an alternative vehicle for consumer and business purpose lending, U.S. MPL must comply with regulatory regimes applicable to both consumer credit transactions and securities transac- tions. Consumer credit is subject to both federal and state laws, and therefore all participants in consumer credit markets are regulated by a number of federal and state regulatory authorities. The Consumer Financial Protection Bureau (‘CFPB’), commenced operation in July 2011, is responsible for administering and enforcing laws and regulations relating to consumer financial products and services at a federal level. It is authorized to prevent unfair, deceptive, or abusive acts or practices (‘UDAAP’) and therefore would have the enforcement authority over all banks and platforms involved in MPL. In addition to consumer credit regulation, MPL platforms are also separately subject to federal and state securities laws. The SEC conducts federal law en- forcement since 2008 and requires each platform to register their public o↵erings as securities, pursuant to the Securities Act of 1933. Therefore, if notes issued are considered as a security, MPL platforms that issue these notes are subjected to SEC Securities regulations. Note that if aplatformplanstoo↵er loans in a private placement (i.e., loans only available for accredited investors), then it is allowed to apply for the exemption and does not have to register securities with the SEC. MPL is currently prohibited in some states (e.g., Iowa). Regulation approaches in other countries are more streamlined. They usually do not treat issued loans as securities, so only consumer credit regulation is applicable. In the United Kingdom, the FCA took over the regulation of consumer credit market from the Oce of Fair Trading (‘OFT’) and started its responsibility for the MPL industry on April 1, 2014. It refers to MPL as loan-based crowdfunding and aims to provide appropriate protection for both investors and borrowers. FCA requires lending marketplaces to have a minimum operating capital, abide client money rules, arrange successor loan servicing, provide cancellation rights to investors, disclose, o↵er dispute regulation provision, and report ongoing positions. Specifically, the information that platforms provide to investors must be relevant and accurate and cannot

24 When Finance Meets Internet Marketplace Lending: a Global Phenomenon overburden investors with too many details, which causes U.K. MPL platforms to disclose less elements than U.S. platforms. Chinese MPL platforms were not supervised by the China Banking Regulatory Commission (‘CBRC’) until July 2015. The lack of regulation has resulted in a wild growth of Chinese MPL. The number of marketplace lenders increased from 50 in 2012 to 2,028 in 2015, although 786 of them either were problematic or failed until June 2015. 49 percent of these platforms are just capital pools used to collect money illegally, whereas 51 percent are caused by mismanagement33. The guideline of MPL regulation was published on July 18, 2015. As the guidance states, marketplace lenders are treated as information intermediaries and not allowed to provide such services as assessing borrowers’ creditworthiness. Besides, MPL platforms are discouraged to guarantee returns. More details are expected to be released later by the CBRC. With the increasing competition and regulation, platforms with poor risk control and high operational risk will be phased out. In the Netherlands, the Autoriteit Financi¨ele Markten (‘AFM’) regulates the platforms that provide loans- or equity-based crowdfunding as investment firms; therefore, a license or exemp- tion is mandatory. At present only two local MPL platforms34 have obtained a license from AFM, Geldvoorelkaar.nl and CrowdAboutNow, and several foreign platforms such as Zencap (a German business loans lender) operate in the Netherlands. Most of them are business loan lenders. There are more platforms operating under the exemption such as Symbid, which says that any crowdfunding business that originated less than 2.5 million35 per year is not required to have a license if they inform their investors of their exemption status. Table 3 briefly summarizes the international regulatory regimes. The regulation is increasing in many countries as regulators start to recognize the importance of alternative financing. The increasing regulation is likely to encourage a rise of marketplace lending as MPL is able to function better as a result of more trust and stability in the financial system.

Table 3: International Regulatory Regimes

Regulatory regime Description Countries U.K. model Platforms need approval from the FCA United Kingdom Exempt market/unregulated MPL is either an exempt Brazil, Ecuador, Egypt, Israel, through lack of definition market or lack of definition in legislation South Korea, and Tunisia MPL platforms are regulated Australia, Argentina, Canada, China, Intermediary regulation as an intermediary, which requires registration Japan, Netherlands, and New Zealand and other regulatory requirements Banking regulation MPL platforms are regulated as banks France, Germany, and Italy MPL platforms are regulated from consumer U.S. model credit and securities sides. Notes are required to United States register with the SEC or to apply for exemption. Source: AltFi, IOSCO Research Department, P2P-banking.com, HJCO Capital Partners

33Wangdaizhijia, July 8, 2015, the Semi-Annual Report of China Online Lending, http://www.wdzj.com/ news/baogao/20950.html, accessed September 17, 2015 34AFM, May 1, 2013, Stappenplan Crowdfunding voor Betere Consumentenbescherming, https://www.afm. nl/nl/nieuws/2013/mei/crowdfunding.aspx, accessed September 15, 2015 35See: https://www.afm.nl/nl-nl/professionals/onderwerpen/crowdfunding-overig

25 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

The Future of Marketplace Lending The future of MPL can be seen from the demand-supply association, which is also the principal used to classify the MPL markets by some MPL insiders36. 1. Procurement Gap Type. Markets where demand of funds is much larger than supply, for example, the U.K., the U.S., Spain, Australia, and Chile. 2. Lending Gap type. Markets where supply of funds is much larger than demand, for instance, Japan37 and Germany38. 3. Developing Countries Type. While supply and demand of funds are seemingly balanced, the fact is that financial service is still immature there and demand for funds has not yet been apparent in these markets. If cultivated, demand will exceed supply, for example, most developing countries. Three main MPL markets are categorized as the one that the demand either is larger or will be larger than the supply. Further, a Morgan Stanley report points out that the Australian market has the potential as it has some characteristics similar to the U.K. market: a high level of online penetration and the lack of unsecured consumer lending and business lending. However, this study will only focus on the U.K., the U.S., and China. European markets outside of the U.K. have been proven tough so far with limited origination despite numerous platforms, and this trend will continue given the lower existing penetration of the unsecured credit, less credit information, and lower online banking penetration, compared to the U.K. market. To better understand these three markets, we estimate the current total addressable market (‘TAM’) and the growth of MPL in the local market under the neutral, bear, and bull scenarios using the compound annual growth rate (‘CAGR’). A conclusion is reported in Table 4 below and more details regarding the calculation are provided in Appendix 1. The cumulative orig- ination amount of MPL loans can reach over $407 billion by 2020 under the neutral scenario, around $281 billion under the bear scenario, and $532 billion under the bull scenario. Table 5 is a summary of TAM estimates from various sources.

36For example, Tomoyuki Sugiyama, the CEO of Crowdcredit (a Japanese startup marketplace lender) classifies MPL markets into three categories following the demand-supply relation. See Masaru Ikeda, December 31, 2014, Meet Crowdcredit, Japan’s Peer-to-Peer Platform for Emerging Markets, http://thebridge.jp/en/2014/12/ crowdcredit, accessed July 1, 2015 37Tomoyuki Sugiyama, 2014, P2P Lending in Japan the Current Situation, http://www.p2p-banking.com/ countries/japan-p2p-lending-in-japan-the-current-situation, accessed July 1, 2015. He believes that the moderate growth of P2P lending is due to the over-banking. In Japan, national average loan to deposit ratio of traditional banks is below 70 percent and banks lend aggressively with an average national lending interest rate of Japanese banks as low as 0.887 percent. 38Claus Lehmann, November 25, 2014, the State of P2P Lending in Germany, http://www.altfi.com/ article/0572_the_state_of_p2p_lending_in_germany, accessed July 3, 2015. Claus suggests that the chal- lenge for German P2P lending services is the very competitive market environment for unsecured instalment loans. The current average interest rate provided by banks is 5.7 percent. This does not leave much room for P2P lenders to compete on price. Furthermore, the government is indi↵erent (at best) to alternative finance and credit card use is not widespread

26 When Finance Meets Internet Marketplace Lending: a Global Phenomenon

Figure 10: Estimates of the TAM and Growth of MPL by 2020, $bn

China (Consumer, 41% CAGR) 450 China (SMEs, 28% CAGR) 400 the U.K. (Consumer, 52% CAGR) the U.K. (SMEs, 44% CAGR) 350 the U.S. (Consumer, 30% CAGR) the U.S. (SMEs, 32% CAGR) 300

250

200

150

100

50

0 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source: HJCO Capital Partners

Table 4: Addressable Market by Region

Unsecured Consumer Loan Origination Year: 2014 2020 Bear 2020 Neutral 2020 Bull China (% of TAM) 12.9 (3.4%) 103 (9%) 137 (12%) 171 (15%) CAGR China 41% 48% 54% U.K. (% of TAM) 0.9 (0.5%) 10 (5%) 15 (8%) 21 (11%) CAGR U.K. 48% 60% 69% U.S. (% of TAM) 7.2 (2.1%) 27 (7%) 38 (10%) 50 (13%) CAGR U.S. 24% 32% 38%

Business Loan Origination Year: 2014 2020 Bear 2020 Neutral 2020 Bull China (% of TAM) 28.3 (2.8%) 118 (8%) 176 (12%) 235 (16%) CAGR China 27% 36% 42% U.K. (% of TAM) 1.1 (1.2%) 6(6%) 11 (10%) 15 (14%) CAGR U.K. 34% 46% 55% U.S. (% of TAM) 4.6 (2%) 19 (7%) 29 (11%) 40 (15%) CAGR U.S. 26% 36% 43% *TAM stands for Total Addressable Market and CAGR stands for Compound Annual Growth Rate. Source: HJCO Capital Partners

27 When Finance Meets Internet Due Diligence

Table 5: Estimated Total Addressable Market of MPL in 2014, all amounts in billions

Goldman Sachs Morgan Stanley Nostrum HJCO Capital Partners Market Size (%) China Unsecured Consumer Credit Lending / RMB2,000–3,000 RMB3,000 RMB2,340 RMB79 (2.6–4.0%) Dollar Equivalent / $325–488 $488 $380 $13 Business Loans Lending / RMB3,000 / RMB6,231 RMB173 (2.8-5.8%) Dollar Equivalent / $488 / $1,012 $28

the U.K. Unsecured Consumer Credit Lending / 62 213 114 0.6 (0.3-0.9%) Dollar Equivalent / $92 $331 $177 $0.9 Business Loans Lending / 22.5 / 60 0.7 (1.2-3.1%) Dollar Equivalent / $35 / $94 $1.1

the U.S. Unsecured Consumer Credit Lending $258 $450 / $339 $7 (1.6-2.8%) Business Loans Lending $186 $284 / $231 $4.60 (1.6-2.5%) Source: Goldman Sachs Global Investment Research, Morgan Stanley Research, Nostrum, HJCO Capital Partners

Due Diligence

MPL industry is booming and the number of MPL platforms has exploded throughout the world in the space of a few years. Therefore, appropriate due diligence must be conducted to select a creditworthy, transparent, and well-managed platform before investing. The analysis will be focusing on platforms in the U.K., the U.S., and China after taking their loan issuance and operational history into account. Platforms in other European countries are not included due to the fact that the market is fragmented, less accessible, not always transparent39,and the small size of platforms. For instance, from the inception in December 2011 to June 2015, Geldvoorelkaar.nl has originated only 764 loans with the total amount over e60 million40 and an average yield of 8.1 percent. The supply of loans would dry up quickly once institutional investors involved. Nine platforms are selected, including: 1) U.K. platforms: Zopa, RateSetter and Funding Circle; 2) U.S. platforms: Lending Club and Prosper; 3) Chinese platforms: Hongling, Lu, Renrendai, and Yirendai. Although Chinese platforms tend to be younger, they have funded alargeamountofloans,whichshouldnotbeignored.Theseplatformsareselectedforthe following reasons: Funding Circle, RateSetter, and Zopa are the dominant players in the U.K. MPL market, • together originating over 70 percent41 of new loans to date. Lending Club and Prosper are the primary unsecured consumer loans lenders in the U.S., • with a 98 percent market share42. The leader of business loans lending in the U.S., OnDeck,

39For instance, Trustbuddy did not share its loan information with HJCO Capital Partners during the contact process. It halted operation over ‘misconduct’ on October 12, 2015. 40June 19, 2015, Meer dan 60 Miljoen Euro “gefund” via Geldvoorelkaar.nl, https://www.geldvoorelkaar. nl/geldvoorelkaar/nieuws/meer-dan-60-miljoen-euro-gefund-via-geldvoorelkaarnl.aspx, accessed September 10, 2015 41Until September 16, 2015, Zopa has originated 1,053,279,013, RateSetter has funded £784,788,985, and Funding Circle has made £816,000,760, with the total consumer loans to be £1,871,102,832 and the total business loans to be £1,876,366,089. Real-time data please see Altfi. 42The Economist, March 1, 2014, Banking without Banks, http://www.economist.com/news/finance-and- economics/21597932-offering-both-borrowers-and-lenders-better-deal-websites-put-two, accessed September 17, 2015

28 When Finance Meets Internet Due Diligence

is not included as it does not disclose its loan book to the public and the majority of its loans are still held on its balance sheet. Aside from the size reason, there are more specific reasons for these four Chinese platforms • being selected. Hongling is the largest online lending marketplace in China and also one of oldest marketplaces. It is relatively more transparent than other Chinese platforms. Besides, it invests in the borrower’s business, which forces it to adopt a strict credit policy and increases its reliability. The parent company of Lu is Ping An Group, the second largest insurance company in China. It has an experienced management team. Renrendai is one of the most transparent platforms in China and its performance can be traced back to the beginning of its business; Yirendai is the subsidiary of CreditEase, the first and largest marketplace lender in China. Platforms’ fundamentals and loans originated from these platforms are compared. Platform comparison is mainly focused on platforms themselves, for instance, their operational history, provided information of loans, (non-)executive committees’ reputation, financial status, and transparency. When comparing loans, the latest expected return and historical return presented by platforms are used. Since the rating policy varies across platforms and only data regarding loans of Lending Club, Prosper, RateSetter, and Zopa is publicly available, the historical per- formance of loans is displayed by comparing the principal unpaid rate based on small interest categories of these four platforms, assuming that risks and interests are matched. The Internal Rate of Return (‘IRR’) that calculates returns using (the timing of) cash flows is reported for only Lending Club and Prosper loans as only their monthly data are available.

Platform Comparison Platform comparison starts with the fundamentals of platforms, including operational history of platforms, basic loans information, (non-)executive committee composition, institutional in- vestors, financial status, and transparency. Platforms with a solid fundamental are more trust- worthy.

Operational history and basic loan information If a platform has operated for a long time, it is more likely that it is able to provide a long perfor- mance record tracing for both the platform itself and loans issued. Short-term data availability is a severe problem for loan performance analysis and selection. Furthermore, platforms with a longer operational history tend to be more sophisticated, stable, and reputable in the local MPL market. Start-up businesses, in some circumstances, have a 50 percent chance of failing within the first 5 years, according to Kirby and Worner (2014). Table 6 summarizes the operational history and tracing history of each platform.

29 When Finance Meets Internet Due Diligence

Table 6: Competitive Landscape of Marketplace Lenders

Year Primary Market Market1 Amount ($mn) Data available Loan term Loan size ($k) Zopa 2005 U.K. P, SB 1.700 10 years 12m–60m 1.6–39 RateSetter 2010 U.K., Australia P, SB 1.239 5years 1m–60m 1.6–39 Funding Circle 2010 U.K., U.S. SB 1.325 5years 24m–60m 6–1,2002 Prosper 2006 U.S. P 4.886 9years 36m–60m 2-35 Lending Club 2007 U.S. P, SB 11.084 8years 36m–60m 1–35 Hongling 2009 China P, SB 13.318 2years 5d–60m 16–1,600 Lu 2012 China P, SB 5.876 1year 1m–36m 1.6–48 Renrendai 2010 China P, SB 1.585 3years 3m–36m 0.5–80 Yirendai 2012 China P, SB 1.835 1year 12m–48m 1.6–80 1 PstandsforPersonalloans,SBforSmallBusinessloans 2 Number shown is for the U.K., 0.1–500 in the U.S. Data is current as of September 30, 2015. Source: Company Data, Lend Academy, HJCO Capital Partners

The five MPL platforms in the U.K. and the U.S. have, on average, operated • longer than the four Chinese MPL platforms. MPL originated in the U.K. in 2005 and spread to the U.S. in 2006. Although the first Chinese MPL platform, CreditEase, was launched as an o✏ine platform in 2006, the first online MPL platform, PPdai, did not start its business until 2009. The online platform of CreditEase, Yirendai, was open in late 2012. Most MPL platforms provide flexible terms of loans except for Prosper and • Lending Club. Although loan term varies from 5 days to 60 months, depending on the platform, 36- and 60-month loans dominate all funded loans. This is a challenge for Chinese platforms as they attempt to guarantee returns. Matching the timing of payments that they receive from the corresponding loans and that they pay out can be dicult when loans have di↵erent terms. Besides loan terms, U.K. and U.S platforms usually focus on providing either business loans or personal loans, whereas Chinese platforms o↵er both, which helps platforms to attract more borrowers. Lending Club, Prosper, Hongling, and Lu have originated more loans than • others. RateSetter and Funding Circle have grown rapidly since their inception and are likely to catch up with Zopa in the coming years. Hongling has grown so fast in 2015 that it has exceeded Lending Club with respect to loan origination (see Figure 11). Yirendai was launched in 2012 and has funded fewer loans, though its parent company, CreditEase, has made over $14 billion loans (with over $9.6 billion secured and over $4.3 billion unsecured)43.

43Jason Jones, May 2, 2014, the Most Important Chinese P2P Lending Companies, http://www.lendacademy. com/the-most-important-chinese-p2p-lending-companies, accessed September 23, 2015

30 When Finance Meets Internet Due Diligence

Figure 11: Founded Loan Amount over the Years

($bn) - 2 4 6 8 10 12 14

Zopa

RateSetter

Funding Circle

Lending Club

Prosper

Hongling

Lu

Renrendai

Yirendai

Before 2012 2012 2013 2014 2015Q1 2015Q2 2015Q3

Source: Altfi, Company Data, NickelSteamroller, Peer-to-Peer Finance Association, Wangdaizhjia, HJCO Capital Partners

Committee Reputation and Institutional Investors The structure of (non-)executive committee board matters, since board members’ professional reputations show not only board members’ confidence in platforms, but can also increase in- vestor’s confidence in platforms. Institutional investors’ interest in platforms also indicates the confidence of sophisticated investors in platforms. Platforms with institutional investors are more interesting to investigate as equity investors usually perform due diligence before their investments; therefore, the number and the quality of institutional investors are good indicators of the reliability of platforms. There is no financial institutional investor in Hongling and Renrendai because they refused the participation of institutional investors. Currently, Hongling is planning to cooperate with institutional investors. Platforms from which accredited investors have purchased loans also seem to be more attrac- tive from due diligence perspective. Table 7 summarizes the current composition of committees and investors and a part of accredited investors who have lent money via MPL platforms.

31 When Finance Meets Internet Due Diligence

Table 7: (non-)Executive Committees and Investors of Marketplace Lending Companies

Company (non-)Executive Committees Equity Investors Buying Loans Phillip J. Riese (Chairman, former President of American Express Tim Draper; Bessemer Venture Partners; Zopa Consumer Cards Services Group); Wellington Partners; Augmentum Capital; the U.K. Government; Metro Bank Jaidey Janardana (COO, former CMO for Capital One UK) Runa Capital; Arrowgrass RateSetter Rhydian Lewis (Chairman, former Lazard Banker) Artemis; Woodford Investment Management / Samir Desai (CEO, former executive at Olivant); Local councils; Universities; Funding Circle Andrew Learoyd (non-executive committee, Index Venture; Union Square Venture; Accel Partners; Rabbit Capital the U.K. Government former COO of the Equities Division in Europe of Goldman Sachs) Stephan Vermut (Chairman, founder of Merlin Securities) Accel Partners; Sequoia Capital; Tomorrow Ventures; BlackRock; Prosper BlackRock Aaron Vermut (CEO, founder of Merlin Securities) QED Investors; Credit Suisse Next Investors; JPMorgan Chase John Mack (non-executive committee, former CEO of Morgan Stanley) Mary Meeker (non-executive committee, KPCB DGF Associates; Union Square Opportunity; Peter J. Thomson; John J. Mack; Lending Club partner of Kleiner Perkins and Queen of Net) Vanguard Group; Google Union Bank; Santander Larry Summers (non-executive committee, former President of Harvard and Secretary of the Treasury) Hongling Shiping Zhou, with over 15-year experience in the stock market / / Gerg Gibb (Chairman and CEO, former Global Senior Director of McKinsey’ Greater China Region) Lu Peng Ye (General Manager, former Vice President of Alibaba Group, Ping An Insurance Group (Parent Company) / COO of Baidu, and Executive of Highland Capital Partners, Apple China, and Motorola Asia) Shishi Zhang (CEO and Executive Director of Renrendai China Business Council, former employee in Temujin ) / / Xinhe Li (Co-founder, former Deutsche Bank Banker) Kleiner Perkins Caufield & Byers; Yirendai Ning Tang (CEO and Chairman of Beijing P2P Association) IDG Capital Partners; Morgan Stanley’s Asia Private Equity Arm; / CreditEase (Parent Company) Source: Company data, HJCO Capital Partners

Financial Status Financial strength of platforms is a critical factor to consider before investing, especially when returns are insured and o✏ine services are involved as the credit risks and physical costs of platforms increase significantly (e.g., the Chinese platforms). However, as long as platforms can control their bad debt rates and operational costs, they can still operate well and serve clients. Due to data limitation, only revenues and expenditures of Lending Club, Prosper, and Yirendai are compared. To be comparable, all accounting items are scaled by the amount of funded loans. Their financial situation is compared each half year since 2014. Since marketplace lenders only function as intermediaries that match investors with bor- rowers, revenues are mainly from origination fees charged to borrowers and service fees (i.e., account management fees and fees charged in the secondary market) charged to clients. As Lending Club and Prosper do not originate loans, their loan facilitation-related income is the transaction fee from WebBank’s transfer. Servicing fees, management fees (only Lending Club charges to accredited clients), and referral fees are a small proportion of the operating revenue. In Figure 12, we can see that the average service fee that Lending Club and Prosper charge to borrowers is stable while the service fee charged by Yirendai has been increasing significantly, from approximately 300 basis points higher to 850 basis points higher than Lending Club and Prosper. This is due to the fact that Yirendai charges a transaction fee of at least 18 percent to borrowers with a higher risk level and the proportion of riskier loans is increasing.

32 When Finance Meets Internet Due Diligence

Figure 12: Revenue / Funded Loans vs. Expenses / Funded Loans, basis points

Yirendai 2015 Jan-Jun LC 2015 Jan-Jun Prosper 2015 Jan-Jun 499 Operating Income Operating Income 528 Operating Income 1,322 Transaction 432 446 Transaction Loan facilitation 1,292 Services 33 41 Services Post-origination 24 Management 13 0 Management Management 0 Others 7 Others 55 Others 6 Net Interest Income 3 Net Interest Income 11 Interest Income 1 Operating Cost 529 Operating Cost 627 Operating Cost 925 S&M 212 S&M 300 S&M 684 O&S 79 O&S 93 O&S 85 G&A 238 G&A 235 G&A 155 Net Income/Loss -30 Net Income/Loss -89 Net Income/Loss 398 2014 Jul-Dec 2014 Jul-Dec 2014 Jul-Dec Operating Income 489 Operating Income 496 Operating Income 924 Transaction 449 Transaction 425 Loan facilitation 907 Services Services 32 33 Post-origination 12 Management 13 Management 0 Management 0 Others -6 Others 46 Others 4 Net Interest Income -7 Net Interest Income 18 Interest income 0 Operating Cost 542 Operating Cost 520 Operating Cost 768 S&M 184 S&M 253 S&M 456 O&S 86 O&S 87 O&S 75 G&A G&A 272 180 G&A 236 Net Income/Loss Net Income/Loss -64 -6 Net Income/Loss 156 2014 Jan-Jun 2014 Jan-Jun 2014 Jan-Jun Operating Income 486 Operating Income 470 Operating Income 736 430 Transaction 452 Transaction Loan facilitation 721 Services 18 Services 20 Post-origination 7 Management 14 Management 0 Management 0 Others 2 Others 21 Others 8 Net Interest Income -2 Net Interest Income 29 Interest income 0 2,054 Operating Cost 572 Operating Cost 535 Operating Cost S&M 221 S&M 280 S&M 1,328 O&S 89 O&S 90 O&S 197 G&A 262 G&A 165 G&A 529 Net Income/Loss -92 Net Income/Loss -35 Net Income/Loss -1,318 Note: Total revenue consists of operating income and (net) interest income; operating income of Lending Club and Prosper includes transaction fees, servicing fees, management fees (only Lending Club charges to accredited investors), and other revenues; Yirendai decomposes Operating Income in a di↵erent way: loan facilitation service fee, post-origination service fee, and others; Operating expenses include origination and servicing, sales and marketing, and general and administrative expenses; net income (loss) is the di↵erence between total revenue and operating expenses after tax. Source: Company data, HJCO Capital Partners The main expenditures for marketplace lenders are construction and maintenance of website, marketing, risk management, and labor. Internet business has high requirements on the safety of information and capital; hence platforms have to spend a lot on the construction and maintenance of their online systems, which accounts for a large proportion of the operating and servicing expenses of platforms. Since MPL is a new industry, marketing is needed to attract clients’ attention. The data from the Nesta report 44 shows that the awareness of alternative finance in the U.K. is quite low and online advertising is the most e↵ective way to introduce MPL to clients. The high proportion of sales and marketing fee of Yirendai is a result of the 5 percent45 referral fee charged by CreditEase. Other Chinese platforms also rely heavily on o✏ine business (including the creditworthiness assessment and acquisition of projects from borrowers), which significantly increase the operating costs. In order to improve potential client’s awareness, platforms need to spend a lot on marketing and sales. Note that the general and administrative fees (‘G&A’) occupied a large proportion of Prosper’s expenditures in 2013, after excluding the $10 million46 of class action settlement,

44Peter Baeck, Liam Collins, and Bryan Zhang, 2014, Understanding Alternative Finance, Nesta and the University of Cambridge 45This percent is going to increase to 6 percent in the near future, according to its public filing. 46http://www.sec.gov/Archives/edgar/data/1416265/000141626513000504/p8k7d19d2013.htm

33 When Finance Meets Internet Due Diligence the G&A would decrease to 343 basis points of total amount of loans originated (not shown in Figure 12). Compared to Prosper and Yirendai, Lending Club spends less on marketing than G&A. Expenditures related to risk management are also important. They are included in G&A of platforms. Nevertheless, the essentially attractive points of MPL loans to investors are still the com- pelling risk-adjusted returns and ecient services; once marketplace lenders seize the lending and borrowing market, they are able to make profits through economies of scale. Currently, profits are small or even negative for most platforms (Lending Club earned a slightly positive income in 2013 and Yirendai earned a positive net income in the first half year in 2015). The cost advantage is the most competitive advantage of MPL over traditional financial industry. In the growth phase, strong capital support from outside usually plays an important role to ensure anormaloperationofMPLplatforms.

Transparency Level Transparency is vital to the long term success of MPL industry. Lack of transparency increases the risk of business failure, and giving investors a full picture is the only way to ensure informed decision making. In the U.S., loans issued in the form of Notes are required to register as securities and hence subject to SEC regulation, which results a high quality public disclosure of platforms issuing Notes. U.K. platforms have relatively lower transparency level under the relevance and simplicity required by FCA. Table 8 outlines the current disclosure level of each platform.

Table 8: Transparency Level and Transparency Score by Platform

Zopa RateSetter Funding Circle Prosper Lending Club Hongling Lu Renrendai Yirendai Expected Net Yields Y Y Y Y Y Y Y Y Y Expected Default Rate Y Y Y Y Y N N N N Historical Net Yield Y1 Y Y Y Y Y N Y N Historical Default Rate Y Y Y Y Y Y N Y N registration registration Loan Book Available Y Y Y Partly N N N required required Max Size of Loan Y Y Y Y Y Y Y Y Y Use of Loan Y N Y Y Y Y Y Y Y Risk Band of Borrower N N Y Y Y N2 N Y N Prospectus Available N N N Y Y N N N N Total 7 5 7 9 9 5 3 6 3 1 Information derived from Liberum the Market Place Lending (MPL) investment opportunity presentation. 2 Investors can check the payment history of borrowers. Source: Company Data, Liberum, Wangdaizhijia, HJCO Capital Partners Prosper and Lending Club have the highest disclosure level. Zopa, RateSetter, Funding Cir- cle, Prosper, and Lending Club provide specific information about the loans originated, whereas a registration is required for RateSetter and Funding Circle to download their loan book. More- over, the quality of loan information provided by Prosper and Lending Club is higher. They share more details of loans and borrowers, including the job title, income, and debt situation of borrowers while Zopa and RateSetter only give loans’ payment information in their loan books. Additionally, the in-depth risk ratings and monthly cash flows of Lending Club and Prosper loans are especially decision-useful as this type of information allows investors to better understand loan performance from various perspectives with raw data. Among Chinese platforms, Renrendai is relatively more transparent, given the fact that its loan performance can be traced to its very beginning and borrowers’ risk bands are available. After Yirendai”s IPO, it will disclose more information and therefore become more transparent.

34 When Finance Meets Internet Due Diligence

Other Information This sub-section compares nine platforms from other perspectives such as business model and bankruptcy remoteness structure. This comparison is shown in Table 9.

Table 9: Other Information

Business Model Legal agreements Provision Funds1 Third-party Trustee Bankruptcy Remote system Regulator Secondary Market Zopa Client Segregated Account Y Y, $16.7m RBS P2PS FCA (U.K.) Y RateSetter Client Segregated Account Y Y, $24.7m Barclays Bank Y FCA (U.K.) Y Some with Link Financial FCA (U.K.) Funding Circle Client Segregated Account Y personal guarantees Barclays Bank Y Outsourcing Limited SEC and CFPB (U.S.) or asset securities Prosper Notary Y N/A WebBank Prosper Funding SEC and CFPB (U.S.) Y Lending Club Notary Y N/A WebBank Partly2 SEC and CFPB (U.S.) Y Hongling Guaranteed Return 3 Y Y, $121m Ping An Bank Partly CBRC Y Lu Guaranteed Return 3 Y N/A Y N CBRC Y Minsheng Bank and Renrendai Guaranteed Return 3 Y Y, $27.2m 4 N CBRC Y China Merchants Bank Yirendai Guaranteed Return 3 Y Y China Citic Bank N CBRC Y 1 Value was updated on October 31, 2014. 2 LCA Trust can be considered as a bankruptcy remote for accredited investors but not for retail investors. 3 Operational model may change due to regulation. 4 Investors’ capital is deposited in Minsheng Bank and the provision fund is deposited in China Merchants Bank. 5 Only VIP clients are able to trade on the secondary market. Sources: Company Data, HJCO Capital Partners

Availability to foreigners–Funding Circle, Lending Club, and Prosper are open to for- • eign institutional investors, and other platforms are only open to domestic residents or institutions. These platforms sign legal agreements with both borrowers and lenders. Protection mechanism. Zopa, RateSetter, Hongling, and Renrendai o↵er provision funds • against loan default. Around 30 percent of loans originated from Lu are secured by insurance companies47. According to the FCA, U.K. platforms have to provide a successor in case of the bankruptcy; therefore, Zopa, RateSetter, and Funding Circle have a bankruptcy remote system and backup service. Prosper transfers all businesses regarding loans to the subsidiary, Prosper Funding, and hence can protect investors from its bankruptcy. In February 2011, Lending Club set up a trust called LCA Trust, which can function as a bankruptcy remote system; however, since LCA Trust serves accredited investors who purchase Certificates in private transactions, it can only protect accredited investors but not retail investors. Liquidity on the secondary market. The existence of the secondary market provides • some liquidity for investors. All nine selected platforms operate a secondary market, al- though not every loan or note can be traded on it. For example, only VIPs of Hongling can enter the secondary market; loans in arrears (have currently missed a repayment) or in default cannot be sold on the secondary market according to Funding Circle term of use; only Notes can be traded on Prosper and Lending Club’s secondary market. The liquidity is limited: on the one hand, investors can only resell or get loans to or from users within the same platform; on the other hand, the secondary market is not as active as the primary market where investors can purchase new loans. Other marketplace lenders often do not have a secondary market. 47Fang Ya, April 15, 2015, Gerg Gibb, the CEO of Lu: the Reasonable Default Rate of Chinese MPL Loans Should be 6–7 percent, http://finance.ifeng.com/a/20150415/13635349_0.shtml, accessed September 17, 2015. With 500 million loans secured and 900 million loans unsecured, around 30 percent of Lu loans are secured by insurance companies.

35 When Finance Meets Internet Due Diligence

Loans Comparison This section presents both expected returns and historical returns of selected platforms from di↵erent perspectives.

Expected Return The expected return or actual return, and default rate are derived from the ocial websites of selected marketplace lenders. According to Table 10, the default rates of Zopa and RateSetter loans are lower than the average write-o↵ rate of U.K. consumer credit, whereas Funding Circle loans’ default rate is higher than the average write-o↵ rate of U.K. business credit. The Lending Club loans’ default rate is slightly higher than the average charged-o↵ rate for all U.S. consumer loans, and the Prosper loans’ default rate is even higher. Renrendai loans have a lower default rate than the bank non-performing loan (NPL) ratio in China, but Lu and Yirendai loans have higher default rates than the average NPL. Hongling loans have a similar default rate as the bank non-performing business loan ratio.

Table 10: Recent Expected Returns and Default Rates of Selected Marketplace Lenders

Expected/Actual return* Default rate** Average default rate in domicile*** Country of Domicile Zopa 5.00%a 0.21%d 2.4–2.6%g U.K. RateSetter 2.90-6.4%a 1.11%d 2.4–2.6%g U.K. Funding Circle 7.30%a 4.6%d 1.2–1.3%h U.K. Prosper 9.33%b 6.62%e 3.55%i U.S. Lending Club 10.06%c 3.77%e 3.55%i U.S. Hongling 13.18%c 2%f 2%j China Lu 8.33%c 5–6%f 1.1%j China Renrendai 12.12%c 0.34%f 1.1%k China Yirendai 11.72%c 2–3%f 1.1%k China *Expected return/interest rates: a the expected return on outstanding principal after expected defaults but before tax in the last 12 monts; b the interest rate provided by Prosper from September 2009 to Novermber 2013; c the interest rate provided by platforms in the last 12 months. For Lending Club, the interest rate from Q1 2010 to Q4 2013 is 14.51%, the default rate is 6.3%, and the realized return is 8.21%. **Default rate: d company website; e loan origination period is July 2009 to Novermber 2013; f interview with CEO of platforms: Hongling, Lu, Renrendai, Yirendai. ***Corresponding average default rates are provided for comparison. They are from the following: g Range based on write-o↵ rates on lending to U.K. individuals in Q3 2014 as reported by the Bank of England in January 2015; h Write-o↵ rates on lending to business in Q3 2014 as reported by the Bank of England in January 2015; i Average charge-o↵ rate for all consumer loans from Q1 2010 to Q4 2014 as reported by the Federal Reserve Bank of st.Louis; j Non-performing business loans ratio in 2014 as reported by the China Banking Regulatory Commission (‘CBRC’); k Non-performing loans ratio in 2014 as reported by the World Bank. Source: the Bank of England, CBRC, Company Data, the Federal Reserve, IOSCO, the World Bank, HJCO Capital Partners Nevertheless, comparing the default rate ocially stated by platforms with the domicile average default rate cannot depict a full image of loan performance. Firstly, platforms target specific borrowers and hence the average default rate of all consumer loans will not be a good representative. For instance, Chinese MPL platforms usually lend to SMEs, whereas most Chinese banks mainly lend money to state-owned and large-scale enterprises with good reputation, both of which are unlikely to default. Consequently, the average default rate of the Chinese MPL industry (over 6 percent48) is much higher than the bank NPL ratio (below 2 percent). Secondly, di↵erent platforms target di↵erent borrower groups, which causes di↵erent loan performance over platforms. If borrowers are less creditworthy, then they are more likely to default. For example, Prosper has a slightly lower FICO requirement (FICO 640) on borrowers 48Gerg Gibb, the CEO of Lu, estimated it to be 67 percent in an interview (see http://finance.ifeng. com/a/20150415/13635349_0.shtml). However, there are other insiders who estimated the bad debt rate to be over 10 percent (see http://news.hexun.com/2014-12-14/171400943.html and http://finance.sina.com. cn/money/lcp2p/20140613/115019405112.shtml).

36 When Finance Meets Internet Due Diligence than Lending Club (FICO 660)49; as a consequence, Prosper loans are likely to su↵er more losses. Thirdly, the way platforms calculate default rate and return rate can be di↵erent; some platforms do not even disclose their calculation at all50. For instance, there are five problems with the default rate disclosed by Chinese platforms51. On the company website of Zopa, Lending Club, and Prosper, it is showed that they calculate the default/loss rate di↵erently52. Last, neither bonds nor credit deposits are comparable to MPL loans due to their di↵erent risks, which means that there is no suitable benchmark for MPL loans. Therefore, we decided to conduct an apple-to-apple comparison between loans with similar interest rates by taking use of raw loan books. Since loan performance can only be analyzed when platforms publish their loan books, the following section will focus on the loan performance of Zopa, RateSetter, Prosper, and Lending Club, with a more in-depth look into Prosper and Lending Club.

Historical Return Prosper and Lending Club loans have higher interest and default rates, whereas the interest and default rates of Zopa and RateSetter loans are much lower. This is mainly due to the fact that these platforms are targeted at di↵erent borrower groups. It is not reasonable to directly compare loan performance based on the loan grade assigned by platforms because platforms usually apply di↵erent grading policy. For example, Zopa assign risk categories A*, A, B, C, and S to loans, Lending Club grades loans with A through G, and Prosper loans have AA, A, B, C, D, E, and HR ratings. RateSetter does not disclose any information about their grading system. However, the interest rate charged to a borrower can be a good indicator of loan risks, if the credit model used is accurate. Thus, the Interest–Principal Unpaid Method is developed to make the comparison free of rating constraints. The key premise of this method is that loan interest rates are set appropriately by platforms based on loan risks. In addition, since loans with di↵erent terms can behave di↵erently, 36-month loans, the main type of loans, are selected as loan samples. We compare loan performance during a specific period to exclude the upward bias of principal unpaid rates. All loans sampled are required to have a complete lifecycle, which means that loans used in this paper are issued before December 31, 2011. The problem of using loans issued after December 31, 2011 is the existence of an upward bias of the weight of prepaid and especially defaulted loans; therefore, using loans with a full life cycle is an important proposition. Note that loans issued before July 1, 2009 by Prosper

49These FICO requirements are applied to loans on public platforms not private platforms. Private platform loan detail is only available to professional investors who have an executed NDA (non-disclosure agreement). 50P2P licai, May 31, 2015, the Secret of P2P Lending: the Actual Bad Debt Rate, http://www.aiweibang. com/yuedu/28630966.html, accessed September 25, 2015 51Renrenjucai, January 4, 2015, Unreliable Bad Debt Rate of P2P Platforms, http://www.huxiu.com/ article/105363/1.html, assessed September 25, 2015 52Zopa: the Actual Default is the total defaulted loan amount as a percentage of amount lent in the calendar year. See http://www.zopa.com/lending/risk-data; Lending Club: the Annualized Default Rate is calculated by dividing the total amount of loans in default by the total amount of loans issued for more than 120 days, divided by the number of months loans in default have been outstanding and multiplied by twelve. Loans issued for less than 120 days are excluded. See https://www.lendingclub.com/public/annualizedDefaultRateHelpPop. action; Prosper: the Annualized Loss Rate is the Actual Loss Rate divided by the dollar-weighted average age of the portfolio in days and then multiplied by 365, and the Actual Loss Rate is the net credit losses corresponding to eligible notes aggregated and then divided by the average daily amount of aggregate outstanding principal for such loans. See https://www.prosper.com/help/investing, accessed October 1, 2015

37 When Finance Meets Internet Due Diligence are excluded because Prosper has changed its business model and credit policy as of July 1, 2009. This means that loans issued before July 2009 are not representative of current loans. Therefore, Zopa loan samples include loans issued between March 2005 and December 2011; sample loans from RateSetter are funded from September 2010 to December 2011; samples of Prosper loans are from September 2009 to December 2011 and samples of Lending Club loans are originated between June 2007 and December 2011. There is also a flaw in using loans originated before 2012: loan interest rates and default rates may change over time. To highlight the e↵ect of using mature loans, Table 11 summarizes the current expected return (interest rate net of default rate) of Zopa, RateSetter, and Prosper loans. This can be compared to the interest rate in our analysis sample (see Table 13). The expected return provided by Lending Club is a bit di↵erent. Lending Club takes 5.05 percent53 as the base rate and adjusts the interest rate charged to borrowers based on the risk and volatility of loans, which makes the “expected return” constant. Instead, the historical return of Lending Club loans is used as a proxy. Note that since Lending Club only discloses historical returns by risk categories, historical returns are alike for loans with the same credit rating but a di↵erent term.

Table 11: Expected Return/Historical Return by Terms

Short-term Long-term Zopa1 2- or 3- year loan: 4% 5-year loan: 5.1% 1-month loan: 2.9% RateSetter1 1-year loan: 2.9% 5-year loan: 5.9% 3-year loan: 4.6% 3-year loan: 5-year loan: AA, 3.61 - 4.42% AA, 4.42% A, 4.30 - 5.47% A, 4.30 - 5.47% B, 5.54 - 6.42% Prosper1 B, 5.54 - 6.42% C, 6.68 - 11.32% C, 6.68 - 7.68% D, 8.19 - 12.47% D, 8.19 - 9.04% E, 9.41 - 13.42% E, 9.41 - 10.06% HR, 10.16 - 13.97% 3-year loan: 5-year loan: A, 5.03% A, 5.03% B, 7.16% B, 7.16% C, 8.63% Lending Club2 C, 8.63% D, 8.45% D, 8.45% E, 9.73% E, 9.73% F, 8.97% F+G, 8.97% G, 8.97% 1 Expected return 2 Historical return Source: Company Data, HJCO Capital Partners To better understand the relationship between yields and risks, the Internal Return of Rate (‘IRR’) for loans funded by Prosper and Lending Club is calculated and used as a supplement of comparison.

Descriptive Statistics Table 12 shows the percentage of sample loans relative to total loans of each platform, in terms

53Lending Club, Interest Rates and How We Set Them, https://www.lendingclub.com/public/how-we- set-interest-rates.action, accessed September 23, 2015

38 When Finance Meets Internet Due Diligence of the loan origination amount.

Table 12: Dollar Amount and Percentage for Total Loans Funded

Sample Total Funded Sample (%) Zopa (£) 117,844,206 789,353,182 14.93% RateSetter (£) 6,115,750 545,550,570 1.12% Prosper($) 95,845,335 2,399,022,041 4.00% Lending Club ($) 275,513,122 9,255,458,156 2.98% Data up until March 31, 2015 Source: Company data, HJCO Capital Partners Since MPL started to take o↵ recently, a large proportion of loans that have not yet matured will a↵ect the principal unpaid rate. After the failure bias was excluded, only a very small part of loans was left in the sample. This is especially critical for platforms that have grown rapidly and issued numerous loans after 2012.

Interest–Principal Unpaid Method The Interest–Principal Unpaid method is used to compare the loan principal unpaid rate of loans with a same annual interest rate. Firstly, we sort sample loans into 20 groups based on the interest rate that platforms charge to borrowers. Those groups are called Rate Groups, introduced by Michael Phillips from Nickel Steamroller. A rate group is a bucket containing loans within an interest-rate range of 2 percent. We then calculate the principal unpaid rate and the value-weighted average of pre-set interest rates of each rate group. The principal unpaid is the percentage of the starting principal that is not yet repaid at the end of maturity.

n Outstanding P rincipalj P rincipal Unpaid = j=1 100% (1) n P rincipal P j=1 j ⇤ where i is the Rate Group and j is the loanP within each Rate Group. Zopa and RateSetter disclose the amount of outstanding principal in their loan books, whereas Prosper and Lending Club do not. Therefore, formula 2 is used to compute the outstanding principal at time ⌧ for Prosper and Lending Club loans.

⌧ Outstanding P rincipal = P rincipal P rincipal P ayment (2) t=⌧ t=0 j j=1 X Since the principal unpaid is measured over the entire holding period and the interest rate is measured annually, the net return is not simply the di↵erence between the principal unpaid and interest rate. The solid bar is the weight of each rate group, and the line measures the loan prin- cipal unpaid rate in the according group. The x-axis on the top is the interest rate of each group.

39 When Finance Meets Internet Due Diligence

Figure 13: Interest Rate vs. Loan Unpaid

0 5 10 15 20 25 30 35 Interest (%) 70% 30% Zopa RateSetter Prosper Lending Club 60% 25%

50% 20%

40% 15% 30%

10% 20%

5% 10%

0% 0% 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 Weight(%) Principal Unpaid This figure reports the comparison among Lending Club, Prosper, Ratesetter, and Zopa. The X-axis is the annual interest rate charged to borrowers, the left Y-axis is the weight of loans in each rate group and the Y-axis at the right side is the principal unpaid rate of loans in each group over the entire holding period. The solid bar represents the weight of loans in each group, and the dots show the loan principal unpaid rate in the according group. The principal unpaid rate is the percentage of the starting principal that has not been repaid at the end of maturity, for each interest range group. Source: Company data, HJCO Capital Partners From Figure 13, we can observe the following: Interest rate: Zopa < RateSetter < Lending Club < Prosper, and Prosper loans • have the widest range of interest rates. Before 2012, interest rates of the majority of Zopa and RateSetter loans were below 10 percent, with most rates between 6 and 10 percent; 97 percent of loans originated from Lending Club o↵ered interest rates of more than 6 percent and 76 percent of loans more than 8 percent; nearly all Prosper loans have interest rates above 6 percent and 98 percent of loans above 8 percent. Particularly, in the sample, Prosper o↵ered clients more choices. Lending Club loan interest rates were between 6 and 16 percent, whereas Prosper loan interest rates were between 6 and 34 percent. This is currently still the case for these four platforms. The range of interest rates is 3.8–5.0 percent for Zopa loans54, 2.9–5.9 percent for RateSetter loans, 5.32–28.99 percent for Lending Club loans, and 5.32–31.90 percent for Prosper loans. The reason that the range of interest rates of Prosper loans is larger than that of Lending Club loans is that Prosper loans are evenly distributed among seven rating categories, whereas Lending Club loans concentrate in high-rating categories, implying that Prosper loans are riskier on average. This is similar to all up-to-date loans (see Figure 14).

54https://www.zopa.com/lending/rates, accessed September 23, 2015

40 When Finance Meets Internet Due Diligence

Figure 14: $% of Loans over Categories until December 2011

HR, AA, E, 4% G, 0% 8% 10% D, E, 15% 13% A, 29%

A, 19% F, 1%

C, 19% D, 24% B, 15%

C, 9% B, 33%

Prosper Lending Club

Source: Company Data, HJCO Capital Partners Lending Club and Prosper give the risk premium to investors; RateSetter and • Zopa put the risk premium into the provisional funds. Lending Club and Prosper allow investors to receive the risk premium borrowers pay, while RateSetter and Zopa deposit the risk premium into their provisional fund, which is used to repay a charged-o↵ loan to investor(s). Therefore, it is expected that the operational models of RateSetter and Zopa would protect investors in a crisis. However, since RateSetter did not start until 2010 and Zopa did not launch the Safeguard fund until 2013, their provision fund model has not encountered a crisis yet and could not be tested; therefore, it is unknown whether their provisional fund is able to cover all the loss of charged-o↵ loans. MPL loans also have di↵erent performance patterns over the years. Therefore, loans are also compared each year. First, we sorted sample loans based on the year when loans were originated, and then calculated the weighted-average interest and principal unpaid rate for all sample loans funded in the same year. An advantage of this method is that it allows the inclusion of all up-to-date loans. A loan cannot be in “Defaulted” or “Charged-O↵” status until 45 months; we thereby track the performance of loans until December 2014. The unpaid loan rate is then defined as the percentage of the amount of unpaid loans on the total amount of loans funded in a certain year. Note that the unpaid loan rate will be lower in recent years as loans are too young to be defaulted or charged-o↵.ThesolidbarsinFigure 15 represent the weighted-average interest rates while the dots are the weighted-average principal unpaid rates of four platforms over time. From Figure 15, we can conclude the following: Decreasing interest rates. The interest rates of Zopa and RateSetter loans have de- • creased to around 5 percent recently. Interest rates of Prosper loan were higher than those of Lending Club loans between 2009 and 2013 but both of them have gradually decreased to around 12 percent. In 2014, the weighted-average interest rate of Prosper loans was slightly lower than the rate of Lending Club loans, while the principal unpaid rate of Prosper loans was lower than that of Lending Club loans.

41 When Finance Meets Internet Due Diligence

Figure 15: Interest vs. Principal Unpaid over the years

interest/principal unpaid (%) 25 Zopa RateSetter Prosper Lending Club 20

15

10

5

0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 This figure shows that the value-weighted average of interest and unpaid loan rate for all 36-month loans issued each year by Zopa, RateSetter, Prosper, and Lending Club. Interest rate is the annual interest rate provided by platforms and weighted by the principal amount. The solid bars represent the weighted-average interest rates while the dots show the weighted average principal unpaid rates of loans. The principal unpaid rate is the percentage of the starting principal that has not been repaid at the end of the maturity for each interest rate group in a certain year. Note that the interest rate is not comparable to the principal unpaid, since interest rate is yearly while principal unpaid is calculated over the entire holding period. Source: Company Data, HJCO Capital Partners Relatively stable but low returns of Zopa and RateSetter loans. Both Zopa and • RateSetter loans have been stable since their launch. The unpaid principal rate of Zopa loans originated in 2008 slightly rises; RateSetter loans have a near zero principal unpaid rate. Compared to Zopa and RateSetter loans, Lending Club and Prosper loans are more volatile and have experienced significant higher default rates in the economy downturn caused by the 2007/2008 financial crisis. However, Zopa and RateSetter loans provide investors a lower interest rate than Lending Club and Prosper loans. This is the integrated result of the operational model, target borrowers, and the economic cycle; therefore, this will always be the case. Risks accompany returns, so we should never look at them separately.

Internal Rate of Return (‘IRR’) Method As the principal unpaid rate does not take the timing factor (i.e., the age of loans and the timing of payments) into account, we compute the IRR, also known as e↵ective interest rate, to measure the value of future cash flows. IRR is the discounting rate r at which the funded amount equals the sum of the present value of payments. It is calculated on the cash flow of a portfolio containing all 36-month loans in each category, using the formula below: p p p P rincipal = i,1 + i,2 + ... + i,n (3) i (1 + r) (1 + r)2 (1 + r)n where i is the rating category and n is the number of payments, e.g., pA,1 is the total repay- ments in A category in the first month. The sample period is the same as the one used in the

42 When Finance Meets Internet Due Diligence

Interest–Principal Unpaid Method.

Table 13: Loan Performance by IRR-Credit Category

Panel A. Prosper Loan Performance Loan Grade Number of Loans Amount of Loans ($ mn) avg. Loan Size ($) FICO Score* Interest Rate (%)* IRR (%)* AA 1306 9.99 7649.31 799 8.58 4.54 A 2601 18.19 6993.82 750 11.02 5.43 B 1903 14.09 7403.31 723 15.78 8.08 C 1716 9.12 5314.89 710 20.46 10.72 D 4526 23.15 5114.41 689 26.13 10.47 E 2998 14.02 4675.61 670 31.67 8.94 HR 2242 7.29 6252.22 667 32.09 11.95 All 17,292 95.85 5542.70 715 20.63 8.45

Panel B. Lending Club Loan Performance A 9581 82.13 8572.01 753 7.32 5.25 B 9254 91.34 9870.82 719 11.09 7.01 C 5466 50.22 9187.48 693 13.74 7.50 D 3197 34.46 10,778.59 683 15.74 8.42 E 808 10.22 12,647.88 676 17.52 9.28 F 217 3.06 14,123.39 674 19.00 3.79 G 80 1.26 15,766.50 673 20.69 3.24 All 28,603 272.70 9533.84 718 11.40 6.79 * FICO score, interest rate, principal unpaid, and IRR are value-weighted averages. Category Founded Amount ($mn) IRR (%)

240 Prosper 10 Lending Club 220 9 200 8 180 7 160

140 6

120 5

100 4 80 3 60 2 40

20 1

0 0 July-December 2009 2010 2011 The solid bar represents the amount of 36-month loans funded each year and the dots are the IRRs of these loans. Source: Company Data, HJCO Capital Partners From Table 13, we can observe some facts about loan performance from IRR perspective. A wider range of risky levels: Prosper. The maximum and minimum FICO score • shows a wider range of the borrowers’ creditworthiness of Prosper than Lending Club, implying more variation of loans’ risks: Prosper AA loans have a higher value-weighted average FICO score than Lending Club A loans, and Prosper HR loans have a lower average FICO score than Lending Club G loans. Most Lending Club loans belong to AA, A, B, C, and D rating categories whilst Prosper loans are more evenly distributed amongst all categories. This is aligned with the previous finding using the Interest–Principal Unpaid Method.

43 When Finance Meets Internet Due Diligence

A higher weighted-average IRR and a smaller loan size: Prosper. The weighted • average IRR of all Prosper loans is higher than that of Lending Club loans between 2009 and 2011. The average loan size of Prosper is smaller than that of Lending Club. Additionally, Lending Club has issued more loans than Prosper in terms of both the number and the funded amount of loans. IRR increases and then decreases as risks increase. The interest rate increases with • the category for both platforms as expected, whereas the IRR increases with the category in the first five categories and then decreases in the two riskiest categories. This implies that the loss due to the default of more loans in a riskier category is lower than the extra payments received due to the higher interest rates, but if the risk becomes too high, then the extra interest payments cannot compensate the additional losses from defaults.

Table 14: Comparison of IRR by Risk Rating Category

Prosper Lending Club Risk Avg. FICO Score Interest Rate (%) Principal Unpaid (%) IRR (%) Risk Rating Avg. FICO Score Interest Rate (%) Principal Unpaid (%) IRR (%) Rating AA 799 8.58 2.67 4.54 A 750 11.02 4.79 5.43 A 753 7.32 3.04 5.25 B 723 15.78 7.39 8.08 B 719 11.09 5.68 7.01 C 710 20.46 9.53 10.72 C 693 13.74 8.57 7.50 D 689 26.13 15.89 10.47 D 683 15.74 10.12 8.42 E 670 31.67 23.00 8.94 E 676 17.52 11.79 9.28 HR 667 32.09 20.79 11.95 F 674 19.00 19.45 3.79 G 673 20.69 22.52 3.24 Sources: Company Data, HJCO Capital Partners

Better performance within each comparable risk category: Prosper. We compare • rate categories with similar FICO scores (see Table 14). For example, instead of Prosper AA loans, Prosper A loans are compared with Lending Club A loans, as their FICO scores are similar. Note that since Lending Club E, F, and G loans have similar average FICO scores to Prosper E loans, they are comparable. The big di↵erence in interest rates of loans with similar FICO scores is due to selected samples. Before 2012, Prosper, on average, o↵ered a higher interest rate to investors than Lending Club did (see Figure 15). Regarding loans in categories with similar FICO scores, Prosper loans have a higher interest rate than Lending Club loans; the IRR of Prosper loans also tends to be higher than the IRR of Lending Club loans in the categories with similar FICO scores. However, even though their FICO scores are almost the same, Prosper loans still have a slightly lower FICO score than Lending Club loans on average.

Empirical Findings by Others As the major online lending marketplaces, Lending Club and Prosper have been analyzed by others through various methods. A widely used one is Returns on Investment (‘ROI’). ROIs are calculated as rates of return to date using an estimated market value of each loan to determine net gain and ROI. As independent third parties, both Lendstats.com and Nickel Steamroller (‘NSR’) take this measurement consistently to conduct an immediate apple-to-apple comparison, although they take di↵erent estimates for loan value. Table 15 presents the estimated percentage of principal loss in remaining principal.

44 When Finance Meets Internet Due Diligence

Table 15: Estimated % of Principal Loss in Remaining Principal used by NSR

Lending Club Prosper Current or Fully Paid 0% 0% In Grace Period 25% 30% Late (16–30 days) 57% 50% Late (31–60 days) 66% 70% Late (61–90 days) 82% 80% Late (91–120 days) 89% 95% Default 91% 96% Charged-O↵ 100% 100% Source: LendStats.com, Nickel Steamroller, HJCO Capital Partners LendStats.com does not disclose its formula but NSR does.

L0 I S P Ln t fee l ROINSR = (4) L0 It P Ln r where It is the total interest, Sfee is the servicingP fees, Plis the estimated principal loss, and r is the interest rate. Other income, such as late fees, are not taken into account. The estimated principal loss is assumed as a percentage of remaining loan principal that will be lost based on loans’ current status. The results from LendStast.com and NSR align with our analysis (see Figure 16). ROIs of Prosper loans are higher than that of Lending Club loans between 2010 and 2014, except in 2011 (LendStats.com estimates) or 2014 (NSR estimates). The lower ROI of Prosper loans than that of Lending Club loans in NSR 2014 estimates is due to the fact that the percentage of loss estimate is much higher for Prosper loans than that of Lending Club loans as shown in Table 15.

Figure 16: ROI Comparison between Prosper and LC Loans using ROI provided by LendStats.com and NSR

2009 2010 2011 2012 2013 2014 12% Prosper 10% Prosper Lending Club 8%

6%

Lending Club 4%

LC_LendStats 2% Prosper_LendStats LC_NSR Prosper_NSR 0% ROI

*LendStats.com and NSR take di↵erent methods to calculate ROI. Source: Company Data, HJCO Capital Partners

45 When Finance Meets Internet Due Diligence

Investing in Marketplace Lending There are four ways for investors to invest in MPL loans. The ideal methodology depends not only on the amount of returns, but also on the level of involvement that investors wish to take. There are analytical tools available for investors who want to become highly involved in the loan selection process. For investors who prefer a more hands-o↵ approach, they can opt to work with fund managers. These methods are discussed below. 1. Direct Platform Investing. This is the original peer-to-peer method of loans investing and many retail investors–particularly the early adopters–choose to continue with this man- ner. Online lending platforms allow investors to open up online accounts, browse through listed loans, and lend money in exchange of interest. This strategy enables investors to manually build a portfolio of notes at a time. This is the most “hands-on” approach to marketplace lending investment. Although it requires a time commitment to research loans and design a strategy, this method can generate statistically higher returns-particularly for those who possess some knowledge in assessing credit risks and accesses to technology. Analytical tools such as Nickel Steamroller and PeerCube help by providing investors with the resources and technologies necessary to analyze loans and compete more favorably with institutions. However, MPL platforms in most countries are not open to foreign retail investors except in Europe. 2. Automated Platform Investing. Instead of manually searching through loans, platforms (e.g., Lending Club and Prosper) o↵er automated investment tools. These automated features allow investors to customize their investing criteria and make use of the platform’s technology to locate loans that meet an investor’s conditions. It saves time, but it is not recommended for investors who seek higher returns or look to compete for coveted loans. The average of Prosper and Lending Club’s automated returns is in the 7 percent range. While it certainly beats most conventional fixed-income returns, those taking time to research and/or build algorithms usually perform better. For investors as well as RIAs who are looking for the best of both worldshigher returns without dedicationa better alternative may be going to a fund manager. 3. Investing through an investment vehicle. Fund managers specialized in MPL could add value by applying proprietary algorithms that instantly analyze the newest notes listed on MPL platforms. They also have the credit analysis expertise, in most cases, to predict defaults with greater accuracy, thus generating higher returns. They are allowed to choose more types of loans. For instance, Lending Club only open near prime loans (unsecured consumer loans with FICO between 600 and 659), small business loans, and patient solution loans to institutional investors. Additionally, a fund o↵ers diversification to a large pool of loans as well as greater liquidity. These funds can help investors who want to invest in loans originated by foreign platforms. A number of funds have emerged that are catered to investors interested in MPL. Involved institutional investors include: BlackRock, Blue Elephant Capital Management, Direct Lending Investments, Eaglewood Capital Manage- ment, HJCO Capital Partners, NSR Invest, Petra Capital Partners, Prime Meridian Income Fund, and Victory Park Capital. 4. Investing through a Robo-advisor. Managed accounts are solutions for unaccredited investors who do not meet the qualifications for private fund investing, but who are seeking higher than automated platform returns yet do not want to spend the time researching

46 When Finance Meets Internet Due Diligence

each note. Lending Robot and NSR Invest are two Registered Investment Advisors that specialize in this area. With a small fee (between 0.45 and 0.90 percent), they will essentially manage the note selection and investing process for smaller investors and financial advisors.

47 When Finance Meets Internet Conclusion

Conclusion

As a sunrise industry, MPL has a significant potential market and is expected to grow as a strong competitor of traditional financial institutions, especially in three major markets (i.e., the U.K., the U.S., and China). Platforms in Europe (excluding the U.K.) are more fragmented and originated fewer loans. Therefore, our investment research is focused on marketplace lenders in China, the U.K., and the U.S. Despite the enormous growth of new global platform initiatives we have the opinion that investors have far less attractive options than borrowers due to the small size of most platforms, the immature stage of the platforms and/or the high risk profile of the borrowers. The most investable platforms share common characteristics; they are highly transparent, well organized and managed, and have a strong financial base. Borrowers are well profiled and risk models are strongly developed and continuously improved due to more available data. The regulatory environment is also an important factor for investors. Europe (ex. U.K.) does not yet have a unified approach and China is still not a transparent place for investors. Based on our research we conclude that only a few platforms are serious investment options at the moment. Lending Club and Prosper are considered as the most attractive regarding due to risk models, IRR, and transparency. Other platforms will certainly follow, as marketplace lending becomes a bigger part of the global financial system.

48 When Finance Meets Internet References

References

Eleanor Kirby and Shane Worner. Crowd-funding: An infant industry growing fast. IOSCO, Madrid,2014.

Karen Mills and Brayden McCarthy. The state of small business lending: Credit access during the recovery and how technology may change the game. Harvard Business School General Management Unit Working Paper, (15-004), 2014.

Thomas Philippon. Has the us finance industry become less ecient? on the theory and measure- ment of financial intermediation. Technical report, National Bureau of Economic Research, 2012.

Yannis Pierrakis and Liam Collins. Crowdfunding: A new innovative model of providing funding to projects and businesses. Available at SSRN 2395226,2013.

Peer Stein, Oya Pinar Ardic, and Martin Hommes. Closing the credit gap for formal and informal micro, small, and medium enterprises. 2013.

49 When Finance Meets Internet Appendices

Appendix 1: Calculation of the Future of the Marketplace Lending Assumptions and Calculations for The U.K.

1. Unsecured and non-student consumer TAM: £114 billion ($177 billion). The total balance of consumer credit lending (excluding student loans) was £169 billion at the end of 2014, including £61 in credit cards and £108 in others. U.K. borrowers typically are those who have already been approved by a bank to borrow and therefore are prime. They turn to marketplace lenders for a better rate, the fast process, and the flexibility in repayments. Considering the high willingness of U.K. residents to use online MPL loans, we estimate that the total addressable market for marketplace lenders in unsecured consumer finance is currently £114 billion ($177 billion)and will grow up to £121 billion ($190 billion) by 2020. The analysis is based on the following key assumptions: 43 percent of credit card balances are held by transactors or those who bear zero interest • rate, according to the 2015 UK card payments annual report55. 10 percent of balances are small loans (i.e., the outstanding balance of loans is less than • £1,000). Clients with small loans do not have the incentive to refinance and the minimum borrowing amount is £1,000 on some platforms (e.g., Zopa). 90 percent of credit card spending is prime (i.e., repaid in full by card holders), according • to the 2015 UK card payments annual report56. 75 percent of loan balances of other consumer lending are likely to switch to online mar- • ketplace lenders, according to a Nesta report57. Unmet demand of individuals and home-owners is estimated to be £3.25– £3.75 billion by • Henry and Craig (2012)58; therefore, we adjust it to £5billion,aftertakingtheeconomic growth into account. The compound growth rate out to 2020 is 1 percent in the unsecured consumer lending, • the average growth rate of TAM in the past three years. 2. SMEs lending TAM: £60 billion ($94 billion). The total balance of SMEs loans was £167 billion at the end of 2014. We estimate that the total addressable market for marketplace lenders in SMEs finance is currently £60 billion ($94 billion) and will grow up to £68 billion ($107 billion) by 2020. The analysis is based on the following key assumptions: Loans with an origination amount less than £3millionareconsideredasaddressablebecause • the maximum loan size of Funding Circle is £1million,whereasthemaximumloanprovided by ThinCats (the second largest U.K. business loans provider) is £3million.

55The UK Card Association, 2015, Annual Report 2015 56The UK Card Association, 2015, Annual Report 2015 57Peter Baeck, Liam Collins, and Bryan Zhang, 2014, Understanding Alternative Finance, Nesta and the University of Cambridge 58Nick Henry and Philip Craig, 2012, Mind the Finance Gap: Evidencing Demand for Community Finance, Community Development Finance Association (‘CDFA’)

50 When Finance Meets Internet

The origination amount of 60 percent of loans is estimated to be over £3 million. This is • adjusted by the 79 percent of loans over $1 million in the U.S. and 67 percent of loans over AUD2 million in Australia. 86 percent of loan balances are likely to switch to online MPL alternative as the survey • conducted by Nesta59 shows. The unmet demand of SMEs is adjusted to be £3billionfrom£1.3 billion, the estimates • made by Henry and Craig60, after taking economic growth into account. The compound growth rate out to 2020 is 2 percent in the SMEs lending. • Table 16: U.K. Addressable Unsecured, non-Student Consumer MPL TAM Estimates, £billion

Legend Outstanding balance of consumer credit lending £1691 (unsecured lending to individuals) excluding student loans Including: credit card £612 A others £1081 B % of transactors or at non-interest bearing 43%3 C Assumed % of small loans (i.e., outstanding balances of loans <£1,000) 10%3 D % of credit card spending repaid in full by card holders 90%2 E Addressable unsecured consumer lending market of refinancing £28 F=A*(1-C)*(1-D)*E credit card debts Assumed % of outstanding balances of other consumer lending 75%4 G that would switch to online MPL Add: unsecured consumer lending market of debts that switch from banks £81 H=B*G Add: the amount of unmet demand £5 I Addressable unsecured consumer loans market size (the U.K.) £114 J=F+H+I 1 the Bank of England 2 the UK Cards association 3 HJCO estimates 4 Nesta survey

Table 17: U.K. Addressable Small Business MPL TAM Estimates, £billion

Legend Outstanding balance of small business lending from MFIs in the U.K. £1671 A Assumed % of original amount >£3mn 60%2 B Less: assumed original amount >£3mn £100 C=A*B Potential market base £67 D=A-C Assumed % of balances that would switch to online marketplace lenders 86% E SMEs loans that assumed likely to switch to online marketplace lenders £57 F=D*E Add: the amount of unmet credit demand £33 G Addressable SMEs loans market size (the U.K.) £60 H=F+G 1 the Bank of England 2 HJCO estimates 3 Community Development Finance Association (‘CDFA’)

59Peter Baeck, Liam Collins, and Bryan Zhang, 2014, Understanding Alternative Finance, Nesta and the University of Cambridge 60Nick Henry and Philip Craig, 2012, Mind the Finance Gap: Evidencing Demand for Community Finance, Community Development Finance Association (‘CDFA’)

51 When Finance Meets Internet

3. The unsecured consumer lending in 2020: £10 billion ($15 billion). In the base scenario, CAGR is assumed to be 60 percent; therefore, the unsecured consumer lending market will grow from £0.58 billion (0.5 percent of TAM) up to £10 billion (8 percent of TAM).

4. The SMEs lending in 2020: £7 billion ($11 billion). In the base scenario, the SMEs lending market is expected to grow from £0.7 billion (1.2 percent of TAM) up to £7billion(10 percent of TAM); therefore, the CAGR is assumed to be 46 percent.

Assumptions and Calculations for the U.S.

1. Unsecured and non-student consumer TAM: $339 billion. Total balance of revolving consumer credit was $890 billion at the end of 2014. We estimate that the addressable market for marketplace lenders in unsecured consumer finance is currently $339 billion and will grow up to $382 billion by 2020. The analysis is based on the following key assumptions: 66 percent of balance is held by transactors, according to CreditCards.com. The percentage • of transactors is also applied to private-label credit cards. 8.82 percent of outstanding balances are small loans (i.e., the outstanding balance of loans is • less than $1,000). We attempt to weed out loans with an outstanding balance of < $1,000, as clients do not have the incentive to refinance and some MPL platforms do not even o↵er loans below $1,000. According to a statistical summary of credit card debt from Statisticbrain61 in July 2015, the total U.S. credit cards debt was $793.1 billion and the average balance per open credit card was $1,157. The average number of open credit cards consumers had in 2012 was 1.96. This translates to roughly 350 million cardholders. The research also shows that 40 percent of cardholders hold a balance less than $1,000. Assuming an average balance of $500 on these cards yields a total balance of $70 billion, or 8.8 percent of the total market balance, that is, under $1,000 and hence not addressable, leaving 91.2 percent as addressable. 66 percent of card balances are held by prime borrowers (i.e., FICO score above 650) ac- • cording to the FICO distribution issued by FICO62. Note that the minimum FICO required by Lending Club for borrowers to be approved for a loan is 660 while it is 640 required by Prosper; most marketplace lenders require at least a minimum 630 credit score. 19 percent of households had unmet demand for general purpose credit (with 12 percent • were rejected and 7 percent did not apply owning to the discouragement) in the past twelve months. Outstanding balance of overdraft lines of credit is excluded due to its lower APR than that • of MPL loans, according to Navy Federal Credit Union63. The compound growth rate out to 2020 is estimated to be 2 percent. • 61Statisticbrain.com, July 1, 2015, Credit Card Debt Statistics, http://www.statisticbrain.com/credit- card-debt-statistics, accessed September 2, 2015 62FICO, February 3, 2014, FICO Score Distribution, http://www.fico.com/en/blogs/risk-compliance/ us-credit-quality-continues-to-inch-forward, accessed September 2, 2015 63It is as low as 13.9 percent. See https://www.navyfederal.org/products-services/checking-savings/ overdraft-line-of-credit-rates.php, accessed October 1, 2015.

52 When Finance Meets Internet

Table 18: U.S. Addressable Unsecured, Non-student Consumer MPL TAM Estimates, $billion

Legend Outstanding balance of general purpose consumer credit $7001 A % of transactors (i.e., consumers who pay o↵ the balances in full each month) 66%2 B % of small loans (i.e., outstanding balances of loans <$1,000) 8.8%2 C Card balance of normal payers with balance over $1,000 $217 D=A*(1-B)*(1-C) % of unmet demand for credit 19%1 E Potential unsecured consumer loans market size (the U.S.) $268 F=D/(1-E) % of card balances of prime borrowers (i.e., FICO score >650) 66%3 G Addressable market for prime general purpose consumer credit card $177 H=F*G Outstanding balance of private-label credit card $714 I Assumed % of transactors 66% B % of prime borrowers 66% G Addressable market for private-label credit card $16 J=I*(1-B)*G Outstanding balance of others (including Retail and Consumer $3351 K Finance, e.g., sales financing and personal loans) Less: outstanding balance of private-label credit card $714 I Less: revolving overdraft lines of credit $425 L Sub-total of other consumer debt $222 M=K-I-L % of prime borrowers 66% G Addressable market for other consumer debt $147 N=M*G Addressable unsecured consumer loans market size (the U.S.) $339 O=H+J+N 1 Federal Reserve Bank of NEW YORK (‘FRBNY’) 2 CFPB Credit Card Database (‘CCDB’) 3 HJCO estimates 4 EQUIFAX 5 Goldman Sachs Global Investment Research estimates

2. SMEs lending TAM: $231 billion. Total balance of SMEs loans on banks’ balance sheets was $1,461 billion at the end of 2014. We estimate that the addressable market for marketplace lenders in SMEs finance is currently $231 billion and will grow up to $265 billion by 2020. The analysis is based on the following key assumptions: The outstanding balance at the end of 2014 was similar to the outstanding balance at the • end of fiscal year 2014. Loans below $500,000 are considered as addressable market since the maximum loan size • originated via Funding Circle and OnDeck is $500,000. 15 percent of loan balances below $100,000, 25 percent of loans balances between $100,000 • and $250,000, and 55 percent of loan balances between $250,000 and $500,000 are unlikely to switch to online marketplace lenders. 10 percent of the balances of SBA 7(a) regular loans are below $150,000, 12 percent are • between $150,000 and $350,000, and 18 percent are between $350,000 and $500,000. Of the SBA 7 (a) regular loans balances, 80 percent are assumed to be issued by banks • and 20 percent are not. Of the proportion issued by banks, 82 percent are sold into the secondary market and hence are not on banks’ balance sheets.

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Table 19: U.S. Addressable Small Business Marketplace Lending TAM Estimates, $ billions

Legend Outstanding balance of Commercial and Industrial loans on bank B/A (excluding farm loans) Original amount <$100k $1311 A Original amount $100k–$250k $501 B Original amount $250k–$1mn $1231 C Original amount >$1mn $11571 Domestic C&I loans on bank B/A $1461 SMEs loans on bank B/A (<$500k)* $2212 D=A+B+C*33.3% Less: assumed unlikely to switch to online marketplace $552 E=A*15%+B*25%+C*33.3%*55% lenders SMEs loans that assumed likely to switch to online $167 F=D-E marketplace lenders Commercial and Industrial loans not on bank balance sheets SBA 7(a) regular loans O/S up to $5mn size** $683 G Assumed % of SBA 7(a) regular loans O/S (<$150k) 10%2 H Assumed % of SBA 7(a) regular loans O/S ($150k–$35k) 12%2 I Assumed % of SBA 7(a) regular loans O/S ($350k–$500k) 18%2 J SBA 7(a) regular loans O/S (<$500k) $27 K=G*(H+I+J) Assume % originated by banks 80%4 L SBA 7(a) (<$500k) loans O/S originated by banks $21 M=K*L Assumed % sold into secondary market 82%4 N SBA 7(a) loans by banks but not on bank B/A $17 O=M*N SBA 7(a) loans O/S not originated by banks $5 P=K-M SBA 7(a) loans O/S not on bank B/A $23 Q=O+P Assumed % of base volume of loans for unmet credit demand 22%3 R Add: the amount of unmet credit demand 42 S=(F+Q)*R Addressable SMEs loans market size (the U.S.) $231 T=F+Q+S

⇤while most U.S. lenders (e.g., OnDeck) currently o↵er loans up to $250k, the total addressable market could grow as lenders increase their loan size over time. ⇤⇤all outstanding balance is till December 2014, except the one of SBA 7(a) loans, which is documented in fiscal year. 1 Federal Deposit Insurance Corporation (‘FDIC’) 2 HJCO estimates 3 US Small Business Administration (‘SBA.gov’) 4 Goldman Sachs Global Investment Research estimates

The unmet credit demand for SMEs is estimated to be 22 percent of current TAM64. • 22 percent is adjusted based on 23 percent from the Spring 2014 Small Business Credit Survey65 conducted by New York Fed and 20 percent from the Joint Small Business Credit Survey Report66 conducted by Federal Reserve Bank of New York, Atlanta, Cleveland, and Philadelphia. The compound growth rate out to 2020 is 2.6 percent in bank lending, 2.7 percent in SBA • 7(a) loans outstanding balance not on bank balance sheets, and 1 percent in unmet demand, resulting in a 2.3 percent CAGR in total.

64Since the current TAM is estimated to be $190 billion, unmet demand for SMEs is around $42 billion, which is lower than Smith and Flannigan-Velasquez (2014) estimates, $57 billion. It is reasonable, as $57 billion is computed from the number of micro-entrepreneurs and not all small businesses with capital needs. 65The Fed of New York, 2014, Spring 2014 Small Business Credit Survey. 23 percent is the sum of 18 percent (discouraged) and 5 percent (priced out). Discouraged and priced out refer to firms that reported not applying for credit because they did not think they would be approved or thought the cost of credit was too high respectively. 66The Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia, 2014, Joint Small Business Credit Survey Report

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3. The unsecured consumer lending in 2020: $38 billion. In the base scenario, the unsecured consumer lending market will grow from $7 billion (2.1 percent of TAM) up today to $38 billion (10 percent of TAM), with the CAGR to be 32 percent in the following six years. 4. The SMEs lending in 2020: $29 billion. In the base scenario, the SMEs lending market is expected to grow from $4.6 billion (2 percent of TAM) today to $29 billion (11 percent of TAM), with a CAGR of 36 percent in the following six years.

Assumptions and Calculations for China

1. Unsecured and non-student consumer TAM: RMB2,340 billion ($380 billion). Total consumer consumption credit balance was RMB15 trillion at the end of 2014, among which, 75 percent was housing mortgage and unsecured consumer credit accounted for just around 15 percent67. Considering its conservative personal credit and low non-performing loan (‘NPL’) rate, a significantly unfilled personal credit demand is assumed in the future. Since the interest rate of credits cards (14.34 percent68) is slightly higher than the average interest rate of marketplace lending (13.76 percent). We estimate the TAM for Chinese marketplace lenders in currently unsecured consumer loans is RMB2,340 billion and will grow up to RMB6,987 billion. The analysis is based on the two following key assumptions: 15 percent of the current unsecured consumer lending market is assumed to be addressable. • The 15 percent is the result after considering the interchangeable interest rates of MPL loans relative to bank loans, the eciency of approval process, and the significant unfilled personal credit demand. The compound growth rate out to 2020 in unsecured consumer lending is assumed to be • 20 percent.

Table 20: China Addressable Unsecured, non-student consumer Marketplace Lending TAM Estimates, RMB billions

Legend Outstanding balance of Chinese consumer consumption lending RMB15,3801 A Assumed % of unsecured consumer credit 15%2 B Addressable unsecured consumer loans market size (China) RMB2,340 C=A*B 1 People’s Bank of China (‘PBOC’) 2 Morgan Stanley Research estimates 2. SMEs lending TAM: RMB6,231 billion in China ($1,012 billion). Total SMEs lending on banks’ balance sheet was RMB23 trillion at the end of 2014, consisting of RMB15 trillion lending to SMEs and RMB8 trillion lending to households for business purposes. Consid- ering the diculty for SMEs to obtain low-interest loans from banks, we assume a significantly unfilled demand. We estimate the TAM for Chinese SMEs marketplace lenders is RMB6,231 billion ($1,012 billion)currently and will grow up to RMB9,008 billion ($1,470 billion). The analysis is based on the following key assumptions: According to the summary of Morgan Stanley Research, only loans from micro-loan compa- • nies, underground lending market, and pawnshop loans have a higher borrowing rate than the MPL loans. Another costly financing method, high-interest private lending, is ignored

67Morgan Stanley Research, 2015, Global Marketplace Lending: Disruptive Innovation in Financials 680.05 percent per day, compounded monthly

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(see Table 2). Besides, the entrusted loans lending has a similar borrowing rate as online MPL but it is less convenient than MPL. Therefore, that loans in these five markets make up the entire MPL market is assumed. The compound growth rate out to 2020 to be 12 percent in micro-loan lending, -10 percent • in underground lending, 15 percent in high-interest lending, 15 percent in pawn shop loans, 15 percent in the entrusted loans, and 15 percent in unmet filled demand, resulting in a CAGR of 3.6 percent in the TAM of SMEs lending. Among the loans originated from pawn shops, 84 percent are lent to SMEs. • Considering the convenience and eciency of online application, 10 percent of entrusted • loans from banks are likely to switch to online MPL. The potential unfilled demand is the di↵erence of the TAM estimated by Morgan Stan- • ley Research and the outstanding balances of micro-finance companies and underground lending.

Table 21: China Addressable Small Business Marketplace Lending TAM Estimates, RMB billions

Legend SMEs credits from micro-loan companies RMB9421 A Add: SMEs credits from underground lending markets RMB3,3891 B Add: high-interest private lending RMB7812 C Outstanding balance of pawnshop loans RMB1013 D % of SMEs loans in pawnshop loans 84%3 E Add: pawnshops loans likely to switch to MPL 85 F=D*E Entrust loans RMB9,3371 G Assume % of entrust loans likely to switch to MPL 10%4 H Add: entrust loans likely to switch to MPL RMB934 I=G*H Add: potential unfilled demand RMB1005 J Addressable SMEs loans market size (China) RMB6,231 K=A+B+C+F+I+J 1 People’s Bank of China (‘PBOC’) 2 China Household Finance Survey (‘CHFS’) 3 Minstry of Commerce of China 4 HJCO estimates 5 Morgan Stanley Research estimates As Chinese marketplace lenders usually provide both consumer credit and SMEs lending, the proportion of each type of loan needs to be assumed to estimate their current market. According to the 2015 semi-annual report of the China online lending report69 released by wangdaizhijia, the number of borrowers in the first half of year 2015 was 1.06 million.

Table 22: Estimated Proportion of Unsecured Consumer Loans and Business Loans

% of borrowers1 the average loan2(RMB) % of consumer loans2 % of business loans2 RMB0.01mn–0.1mn 84.11% 0.055mn 100% 0 RMB0.1mn–1mn 13.59% 0.55mn 50% 50% RMB1mn–10mn 2.10% 5.5mn 0 100% >RMB10mn 0.20% 15mn 0 100% 1 wangdaizhijia.com 2 HJCO estimates

69Wangdaizhijia, July 8, 2015, the Semi-Annual Report of China Online Lending, http://www.wdzj.com/ news/baogao/20950-all.html, accessed September 17, 2015

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The total amount of consumer loans originated was RMB89 billion (31 percent) and the total funded amount of SMEs loans was RMB194 billion (69 percent). Therefore, 31 percent of loans are assumed to be unsecured consumer loans and 69 percent of loans are assumed to be SMEs loans. Consequently, the unsecured consumer credit lending and the SMEs lending in 2014 was RMB79 billion ($13 billion) and RMB173 billion ($28 billion) respectively. 3. The unsecured consumer lending in 2020: RMB838 billion ($137 billion). In the base scenario, the unsecured consumer lending market will grow from RMB79 billion (3 percent of TAM) up to RMB838 billion (12 percent of TAM); therefore, the CAGR is 48 percent. This is the adjusted from the average growth rate of credit card outstanding balances over past three years, 43 percent, by taking unmet demand into account. 4. The SMEs lending in 2020: RMB1,081 billion ($176 billion). In the basic scenario, the SMEs lending market is expected to grow from RMB173 billion (3 percent of TAM) today to RMB1,081 billion in 2020 (12 percent of TAM); therefore, the CAGR is assumed to be 36 percent in the following six years.

Appendix 2: Historical Exchange Rates The exchange rates used for various calculations throughout the paper.

Table 23: Historical Exchange Rate

12/31/2011 12/31/2012 12/31/2013 12/31/2014 09/30/2015 Euro - USD 1.2949 1.3215 1.3766 1.2155 1.1216 GBP - USD 1.5453 1.6153 1.6488 1.5532 1.5153 RMB - USD 0.1571 0.1583 0.1636 0.1625 0.1571 GBP - Euro 1.1933 1.2258 1.1982 1.2777 1.3510 Source: oanda.com/currency/historical-rates/

Appendix 3: Country Abbreviations Abbreviations Used in Figure 3.

Table 24: Country Abbreviations

Country abbr. Country abbr. Country abbr. Argentina AR France FR New Zealand NZ Australia AU Germany DE Spain ES Brazil BR India IN Sweden SE Canada CA Italy IT Switzerland CH China CN Japan JP The United States US Estonia EE Latvia LV The United Kingdom UK Finland FI Netherlands NL The United Arab Emirates AE

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